05-18-2026
As I noted in an earlier post on the magic of monetary policy, the “expectations channel” of interest rates is the primary channel for the Federal Reserve’s monetary policy to affect the economy. This raises the challenge of what the Fed should do when its policy rate reaches the “effective lower bound” (ELB) as it did on December 16, 2008. At this point, the Fed can no longer lower its policy rate to put downward pressure on longer-term interest rates to provide stimulus to the economy.
Earlier academic research by Eggertson and Woodford in 2003 argued that the Fed could still reduce long-term interest rates by using “forward guidance” (FG). That is, if the Fed could convince markets and the public that its policy rate would remain at the ELB longer than they currently expect, then changing their expectations would put downward pressure on long-term interest rates with no change in the current Federal Funds rate.
There is an important difference between forward guidance and transparency. Over time, the Fed became more transparent on their forecasts and how they formulate monetary policy. This transparency allowed the markets and the public to “think like the Fed” and to better predict future Fed policy decisions. As a result, the expectations channel of monetary policy became more effective, shortening the lags in which it affects the economy. The aim of FG is quite different in that the intention is to change monetary policy expectations even if they accurately reflect available information.
The Fed’s use of FG went through three stages: qualitative, calendar-based and threshold-based. The Fed introduced qualitative FG on December 16, 2008, when its statement indicated that “weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.” The Fed strengthened this qualitative FG on March 18, 2009, when it changed “some time” to “for an extended period.”
Slightly over two years later, the Fed introduced calendar-based FB. On August 9, 2011, the Fed statement indicated that conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” The date was subsequently pushed out two times. On January 25, 2012, the statement said, “… at least through late 2014.” Then, on September 13, 2012, the Fed revised the timing to “… at least through mid-2015.”
At the end of that year at its December meeting, the Fed evolved to a threshold-based FG. The statement said, “… at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
For FG to be effective, the Fed must carry it out (or strengthen it) going forward. If the Fed later changes its mind and tightens policy in a manner inconsistent with the earlier FG, then the markets will not believe in any future FG by the Fed. Once broken, the tool is irreparable. By design, FG ties the hands of future FOMC committees.
This highlights an inherent governance problem with FG. The FOMC committee announcing the FG is not the same committee(s) that must carry it out in the future. Federal Reserve Presidents (with the exception of the New York Fed) rotate on and off of the FOMC each year and Governors rotate off as their terms expire or they retire early. FG means that voting members of future FOMCs effectively lose their votes over the appropriate monetary policy. Some of these voting members may have been non-voting participants at the earlier FOMC meeting where the FG was approved. They may even have voiced concerns about the FG in the policy go-around, but they did not have a vote. As a matter of sound governance, current FOMC members should not have the ability to take away votes from future FOMC members.
While FG uses the traditional expectations channel for monetary policy to provide stimulus to the economy at the ELB, it does this in a non-traditional manner. Forward guidance reduces Fed transparency, as its goal is to influence rather than to inform market expectations. This is a perilous path to travel. As President Abraham Lincoln said, “We must not promise what we ought not, lest we be called on to perform what we cannot.” The FOMC should not promise a future path for monetary policy in an uncertain economic future.
Joseph Tracy is a Distinguished Fellow at Purdue University’s Daniels School of Business and a nonresident senior fellow at the American Enterprise Institute. Previously he was executive vice president and senior advisor to the president at the Federal Reserve Bank of Dallas. He regularly contributes insightful posts about financial markets to Daniels Insights.
