Discussion of

“Forward Guidance by Inflation-Targeting Central Banks”

By Michael Woodford

Sveriges Riksbank Conference

“Two Decades of Inflation Targeting: Main Lessons and Future Challenges”

June 3, 2013

John Williams

Federal Reserve Bank of San Francisco

The opinions expressed here are those of the author and do not necessarily reflect the views of anyone else in the Federal Reserve System.

The Ascent of Inflation Targeting

Pre-Inflation Inflation Flexible FIT with policy NGDP Targeting Targeting IT projections Targeting?

• Competing Visions of Inflation Targeting– “Classic” IT vs. Woodford’s Ideal IT

• Forward Guidance– Experience of the Federal Reserve

• Nominal GDP Targeting– Theory and Practice

Roadmap of Discussion

• “Classic” Inflation Targeting– Conservative: limited goals – Primacy of inflation objective– Communication focused on anchoring inflation

expectations– Avoidance of policy errors of past

• Woodford’s Ideal IT– Ambitious: implement & communicate optimal

policy approach– Fine-tuning of policy and communication

Competing Visions of IT

“Classic” Inflation Targeting (RBNZ)

• Implements optimal policy under commitment (yielding unique RE equilibrium)

• Communicated in terms of a criterion of forecasts of target variables

• Performs well in presence of zero lower bound on nominal interest rates

• Robust to forecast/policy errors

• Conclusion: variant of price level targeting or nominal GDP targeting preferred

Woodford’s Criteria for Ideal IT

• The Federal Reserve’s use of forward guidance has evolved dramatically over the past decade

– Policy statements now make explicit reference to economic conditions for policy action (for funds rate liftoff and continuation of asset purchases)

– FOMC quarterly projections of the funds rate

• Forward guidance has clearly affected market expectations of future path of rates (Swanson and Williams 2012)

Forward Guidance

See also: Bernanke-Reinhart-Sack (2004), Kohn-Sack (2004), Gürkaynak-Sack-Swanson (2005), Campbell-Evans-Fisher-Justiniano (2012)

Effectiveness of Forward Guidance: Event Studies

Effectiveness of Forward Guidance: Shift in Private Forecasts

Effectiveness of Forward Guidance: Reduced Uncertainty based on Options Data

Explicit forwardGuidance (US)

Probability that U.S. funds rate < 50bp in 5 quarters

Probability that UKLibor rate < 75bp in 12 months

• Lack of strong theoretical foundations and empirical evidence on what constitutes “best practice” CB communication.– Why is CB communication necessary? What is source of

breakdown of rational expectations equilibrium?– How does one communicate intentions vs. commitment,

uncertainty and disagreement?

• Public’s “rational inattention” creates limits and unavoidable tradeoffs for CB communication:

– Central bank communication is allocated only so much bandwidth, which calls for simplified clarity on a few points, rather than comprehensive description of policy

– Example: FOMC 6½ unemployment rate threshold

Forward Guidance: Practical Constraints (I)

• Diversity of views makes it difficult to agree on and describe “consensus” policy reaction function (or targeting criterion); instead, FOMC communicates through multiple channels:

– consensus statement on longer-run goals and policy principles

– FOMC policy statements and minutes– quarterly policy projections based on individual assessments

of appropriate monetary policy– speeches and testimony

• As a result, much of communication centers on turning points such as rate liftoff and end of asset purchases, rather than more general policy reaction function.

• At times, multiplicity of communication channels can interfere with signal clarity

Forward Guidance: Practical Constraints (II)

• NGDP Targeting has advantages of PLT:– Approximates optimal policy

– Robust to natural rate and model uncertainty (Orphanides and Williams 2002, 2006)

– Performs well in presence of zero lower bound if credible and understood by public (Williams 2006)

• Imposes “balanced approach” to objectives ( =1 )

• Risk sharing of nominal debt contracts– Koenig (IJCB 2013)

• Relatively easy to communicate to public (?)

Nominal GDP Targeting: Theory

• NGDP targeting may be robust to high degree of natural rate and model uncertainty

• Example: robust difference rule (OW 2006)i = 1.1(π-π*)− 2.6u 1.1{y + π - (y* + π*)} i = 1.1{y + p - (y* + p*)} + const.

u: unemployment ratey: real GDP (u & y linked by Okun’s Law)

Nominal GDP Targeting: Theory

• Unanticipated shifts in potential output growth translate into persistent deviations of inflation from desired target

• Policy should be symmetric (example: what would PLT or NGDP targeting imply for the UK today?)

• Relies on credible commitment to not let “bygones be bygones” which may be difficult to communicate or implement in practice.– For example, if PLT had been implemented in US in 2004,

policy would be leaning against a price level gap because of the bump in inflation over 2005-08.

Nominal GDP Targeting: Practice

Revisions to CBO’s Estimates of Potential GDP

12000

13000

14000

15000

16000

17000contact

Source: Bureau of Economic Analysis, CBO

Real GDP XlabelYlabelLeft Billions of 2005 $

2007 Vintage Potential GDP

2013 Vintage Potential GDP

subtitle

Real GDP

GDP

Price Level Base Year Matters

-3

-2

-1

0

1

2

3

4contact

U.S. GDP Price Level Gap (2% trend growth)XlabelYlabelLeftPercent

2004 Base Year

2007 Base Year

Source: subtitle

How Big is the Nominal GDP Gap?

Output gap Price level gap Inflation gap Policy gap (equal weights)

CBO 2007( -11% )

2007 base year( - 2% )

- 13%

CBO 2013( - 5½%)

2004 base year( + 1% )

- 4½%

CBO 2013( - 5½%)

- 1% - 6½%

• If nominal GDP target based on 2007 estimate of trend nominal GDP (up to now), monetary policy would need to engineer a 7½ percentage point increase in price level.

• For example, that would imply 3½ percent inflation on average over the next 5 years, which would be hard to explain and could unmoor inflation expectations.