Fed Study Calls Strategy Based on Promise a Success Economy Benefited From Pledge to Keep Rates Low for 'Considerable Period'
By JOSEPH REBELLO
WASHINGTON -- The unusual strategy adopted by the Federal Reserve in the summer of 2003 for stoking the U.S. economy without cutting interest rates was a clear success, researchers at the U.S. central bank have concluded in a new study.
The study, led by Fed Governor Ben Bernanke, says the central bank managed to exert powerful effects on longer-term interest rates merely by promising to keep the key short-term federal funds rate low for a "considerable period." Those influences were at least five times stronger than the average effect of actual interest-rate changes from 1991 onward.
The study's conclusions validate the confidence that many Fed policy makers showed late in 2002 and early 2003 as Wall Street fretted that the central bank was running out of "ammunition" to boost the economy. By July of 2003, the Fed had dropped the federal funds to a 45-year low of 1% without generating what it could consider a "sustainable" economic recovery.
The policy makers decided at that point to stop cutting interest rates. They switched instead to a strategy that Mr. Bernanke and his colleagues call "policymaking by thesaurus." For the first time in its history, the Fed began to make public statements about how it might change interest rates over a horizon beyond six to eight weeks.
'Considerable Period' Language
On Aug 12, 2003, the Fed's monetary-policy committee announced that it believed "the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period."
For the next five months, the committee retained the "considerable-period" promise. Then it began to tinker with the language, making subtle changes that slowly altered the meaning of the promise.
In late January 2004, the Fed's Open Market Committee dropped the phrase "considerable period" and replaced it with an assurance that the Fed could be "patient in removing its policy accommodation." In May, the language shifted again -- the committee said it believed policy accommodation could be removed "at a pace that is likely to be measured."
In their study, Mr. Bernanke and his co-authors provide hard evidence that the Fed's ability to steer the economy often depends far more on what it says than on what it does with interest rates. Moreover, they say, the Fed's "considerable-period" maneuvers had an even bigger effect on longer-term interest rates than previous statements of the FOMC.
"Shaping investor expectations through communication does appear to be a viable strategy," Mr. Bernanke and his co-authors, Vincent Reinhart and Brian Sack, concluded. "By persuading the public that the policy rate will remain low for a longer period than expected, central bankers can reduce long-term rates and provide some impetus to the economy, even if the short-term rate is close to zero."
Federal-Funds Rate
The federal-funds rate -- the central bank's main tool for controlling the economy -- is by definition a limited one, since it applies directly only to the overnight loans that commercial banks make to one another. Accordingly, the Fed aims for indirect effects when it changes the funds rate, seeking to influence a wide spectrum of market interest rates.
Mr. Bernanke and his colleagues studied the effect on financial markets of 116 decisions made by the Fed's monetary-policy committee since July 1991. Of those, 56 were accompanied by a public statement. Thirty-one of those statements contained a surprise for financial markets -- either in terms of the committee's judgment about the state of the economy, or in terms of its description of the policy outlook.
The researchers found that investors' reaction to surprising statements was much larger than the reaction to interest-rate changes themselves. On average, a surprising change in the federal-funds rate caused the yield on the one-year Eurodollar futures contract to rise or fall a mere three basis points within an hour of the Fed announcement, the study showed. A basis point is one hundredths of a percentage point.
But the average reaction to surprising statements was 11.5 basis points. The reaction during the Fed's "considerable-period" maneuvers in late 2003 and early 2004 was larger still -- 17 basis points.
Salutary Effects
Those maneuvers had other salutary effects as well, the study says. They "reduced the volatility" of public expectations of Fed policy, allowing investors to make more accurate guesses about the timing and magnitude of Fed interest-rate changes. They even taught investors how to accurately adjust their expectations in response to new economic data.
Before September 2003, for example, yields on 10-year Treasurys tended to rise an average of four basis points whenever the government's monthly report on nonfarm payrolls showed that job gains exceeded Wall Street's expectations by 100,000 or more. After that point, however, the reaction was 11 basis points.
The Fed researchers suggest that was because the central bank's statements had begun to make the considerable-period promise contingent on the state of the job market. "Policy expectations simultaneously became more sensitive to certain types of macroeconomic news, such as the payroll report," the study says.
Fed researchers typically don't provide public comment on their work. But Mr. Sack, who recently moved from the Fed to the economic-forecasting firm Macroeconomic Advisers, said the study validated the wisdom of the Fed's communications strategy last year.
"The statements had a direct effect on policy expectations, causing investors to push back the expected onset and pace of policy tightening," he said. "They also conditioned market responses to other incoming data, by highlighting those variables that were important to the policy outlook. Overall, these effects helped to move expectations closer in line with the policy path that was eventually realized." --
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