Discussion of “Forward Guidance by Inflation-Targeting Central Banks” By Michael Woodford

1. Discussion of “Forward Guidance by Inflation-Targeting Central Banks” By Michael Woodford SverigesRiksbank 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.

2. The Ascent of Inflation Targeting Pre-Inflation Inflation Flexible FIT with policy NGDP Targeting Targeting IT projections Targeting?

3. Roadmap of Discussion • 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

4. Competing Visions of IT • “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

5. “Classic” Inflation Targeting (RBNZ)

6. Woodford’s Criteria for Ideal IT • 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

7. Forward Guidance • 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)

8. Effectiveness of Forward Guidance: Event Studies See also: Bernanke-Reinhart-Sack (2004), Kohn-Sack (2004), Gürkaynak-Sack-Swanson (2005), Campbell-Evans-Fisher-Justiniano(2012)

9. Effectiveness of Forward Guidance: Shift in Private Forecasts

10. Effectiveness of Forward Guidance: Reduced Uncertainty based on Options Data Probability that U.S. funds rate < 50bp in 5 quarters Probability that UK Libor rate < 75bp in 12 months Explicit forward Guidance (US)

11. Forward Guidance: Practical Constraints (I) • 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

12. Forward Guidance: Practical Constraints (II) • 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

13. Nominal GDP Targeting: Theory • 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 (?)

14. 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*)− 2.6u  1.1{y + π - (y* + π*)}  i = 1.1{y + p - (y* + p*)} + const. u: unemployment rate y: real GDP (u & y linked by Okun’s Law)

15. Nominal GDP Targeting: Practice • 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.

16. Revisions to CBO’s Estimates of Potential GDP

17. Price Level Base Year Matters

18. How Big is the Nominal GDP Gap? • 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.