Can talking differently boost the economy? It sounds like a silly idea, but as long as the talkers have the right jobs, there’s considerable theoretical reason to believe they can make a huge difference. New research from the Federal Reserve Bank of Chicago shows that talk does matter and that the Fed could significantly improve the economy by choosing its words better.
The messenger for all this was Charles Evans, the president of the Chicago Fed, who is waging a low-profile war to revive the economy by changing how the Fed speaks. Last week, at the annual Brookings Papers on Economic Activity conference, Evans tried to make this case to an elite audience of economists and policymakers. His paper, “Macroeconomic Effects of FOMC Forward Guidance,” co-written with Chicago Fed staffers, is one of the most important policy arguments out there today, arguing that the central bank could significantly stimulate the economy simply by rephrasing its statement that “economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels of the federal funds rate through late 2014.”
When faced with a recession and high unemployment, advanced economies ask the central bank to cut interest rates. Lower rates spur interest-sensitive purchases, primarily in vehicles for both consumer and business-investment purposes, and in physical structures like housing, offices, warehouses, and storefronts. This helps reduce unemployment in highly cyclical sectors and helps stabilize the economy by bolstering incomes. Conversely, if inflation is too high, the central bank does the reverse and raises interest rates. But economists have long observed that the short-term rates the Fed controls can’t really impact decisions about longer-term investment and durable goods. The relevant issue for those decisions is longer-term interest rates.
These long-term rates are driven by expectations about the future. So even though the Fed does not set long-term rates, how the Fed talks shapes expectations about what that future will be.
Evans says that the Fed can guide these long-term expectations in two ways. First, what he calls “Delphic” guidance is a Fed observation that the future economy is likely to be weak and therefore future rates are likely to be low. What he calls “Odyssean” guidance, by contrast, is a Fed promise to keep rates low, giving investors and potential durables goods customers confidence that come what may, the low rate climate will continue into the future. The Fed’s current language is somewhat ambiguous between the two, with formally Delphic statements often receiving Odyssean interpretations in the press and Fed watchers in the media and the business community receiving clear informal guidance that the statements are meant to stimulate the economy.
Much of Evans’ paper is dedicated to attempting to mathematically disentangle the market reaction to recent Fed language shifts in order to demonstrate that Odyssean signals are being heard. The real meat of the argument, however, is that the Fed should clear the confusion up with a much simpler and clearer statement. Specifically, Evans wants the Fed to promise that it won’t raise rates until unemployment falls below 7 percent, unless inflation rises above 3 percent.
That’s solid Odyssean guidance. It tells you that if you were at all considering investment in business equipment, structures, automobiles or the like, today would be a good day to take the plunge. Either nominal rates will stay low for a long time, or else the economy will recover unexpectedly quickly (turning your investment into a good value), or else the inflation rate will be unexpectedly high (reducing the real interest rate you pay). Either way, you want to invest today, and that should boost the economy.
The discussion that followed Evans’ paper at Brookings proceeded under the Chatham House rule, meaning I can’t specifically say who was there and who said what. Participants included current and former (and perhaps future) officials at the Fed, at international economic agencies, and from the executive branch. There was a lot of quibbling over whether Evans’ math really showed exactly what he said it did, and plenty of explanation of why the Fed would never consider acting the way he suggests it should, but precious little dispute of the idea that his proposal would boost the economy. Several people worried that opening the door to even a little bit of inflation would produce uncontrollable price spirals, but nobody could quite explain why. Reading between the lines a bit, the main problem experts have with Evans’ proposal is risk-aversion. Policy elites consider the achievement of low and stable inflation since the mid-1980s to be a major achievement and don’t want to do anything that jeopardizes it in any way, even if the cost is a years-long spell of mass unemployment.
This is an irrational attitude. What’s more, for actual public officials, it’s an illegal one. The Federal Reserve has a statutory obligation to give equal weight to price stability and maximum employment, which it’s clearly failing to do. With the economy still millions of jobs short of full employment, the Fed has an obligation to think of more aggressive policies to get Americans back to work. Evans and his team in Chicago have put a concrete plan to do that on the table, and if his colleagues at the Fed don’t like it, they should be obligated to come up with a better one.
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