In a previous post, I brought up the idea that the Fed could have a formal data-dependant rule:
“…It is not important for the public to know the weightings, neither is it desirable. It is enough that the public know it is not a random decision.
To maintain credibility, the Fed has to confirm that it does indeed have a target, and yet in trying to achieve this, it must consider external factors as well – just like an archer estimating the distance of the bullseye, who must also consider the direction of the wind to be accurate in the trajectory of his arrow.”
Another interesting idea that has been suggested by the Bank of England is the “Threshold-based Forward Guidance”, or TBFG.
Here, the policymaker makes a state-contingent commitment to hold the policy rate at the zero lower bound in a way that ensures that specific macroeconomic variables such as inflation do not breach particular ‘thresholds’.
Furthermore, TBFG can also act as a hedge against asymmetric effects of shocks. From the abstract,
That is because if further adverse shocks arise, prolonging the recession, exit would be expected to occur later and the policy would provide additional stimulus. In contrast, if positive shocks arrive, so that the economy recovers more quickly than originally expected, exit would be expected to occur sooner, thereby removing some of the policy stimulus. This hedging property of TBFG also means that there is a relatively low incentive for policy makers to renege on the policy, unlike lower-for-longer policies that depend purely on calendar time.
And on the need to define the set of feasible state-contingent commitments (bold mine),
One key contribution of our paper is to show that TBFG policy is incomplete in the absence of specific guidance about how the policymaker intends to interpret the threshold conditions. Put differently, in order for the private sector to be able to understand the policy, it is not sufficient for the policymaker to announce a set of thresholds for macroeconomic variables. It is also necessary for the policymaker to announce precisely what the threshold conditions mean. There are many different interpretations of the threshold conditions. The approach we take in this paper is to define the set of feasible state-contingent commitments as those in which the threshold conditions are not breached in any state of the world in which the forward guidance regime remains in effect. And then to select a unique equilibrium from that set as that which maximises the expected duration of the regime.
Our baseline results compare the behaviour of the model under time consistent policy and various forms of forward guidance with thresholds on both inflation and the output gap. We find that appropriately calibrated TBFG policies can substantially improve welfare compared with fully time consistent behavior.
Part of the mechanism behind the result is straightforward. In line with the ‘textbook’ remedy to mitigating the ZLB constraint, TBFG can be used to stimulate activity and inflation today by promising higher inflation in the future. But, as well as improving outcomes in expectation, TBFG can also be used to manage the variance of possible outcomes. Agents know that if further negative shocks arise, prolonging the recession, the policy rate will be held at the ZLB for longer. By contrast, if positive shocks arrive, so that the economy recovers more quickly from the recession than originally expected, then exit from the ZLB will occur sooner and the policy stimulus will be removed.