# Monetary Policy Lower Bounds

I will probably publish a much longer post after I edit out some of the rudeness. This isn’t just convention season it is also Jackson Hole Monetary Conference season. There is quite a lot of discussion of forward guidance, that is public statements about monetary policy in the medium distant future. Many pages of it are in this paper by Michael Woodford.

I will use the phrase as he does to refer to guidance regarding future safe overnight rates (the federal funds rate for the USA). He treats the direct effects of massive asset purchases separately. Here I will pretend that the only thing the FOMC does is target the federal funds rate, so forward guidance means statements about what the target will be a few years from now. I will assume that the Fed surely can’t precommit beyond Bernanke’s current term that is roughly beyond the next 5 years. The guidance can be conditional. It could be that the target rate will be below 0.25% until nominal GDP is within 1% of the pre-2007 trend (with a published estimate of the trend for precision).

The point of forward guidance is that even if the monetary authority can’t drive current short term nominal rates significantly lower (since they are already essentially zero) it can cause lower expected future short term rates. The aim could be to cause increased mid term expected inflation.

The problem is that there is a zero lower bound for expected future interest rates. Given my assumptions, all effects of forward guidance should show up in the 5 year constant maturity treasury interest rate series. I note that bond traders pay obsessive attention to everything FOMC members say and it is very possible that the guidance will influence their beliefs, but not those of home builders, potential home buyers or even mortgage loan officers.

The current Treasury 5 year rate is 0.66% . I think the outer limit of possible forward guidance would be to lower it by about 0.5%. This, it seems to me, is not a big enough deal to justify the huge spillage of ink and killage of trees. Things were very different fro mid 2009 through early 2010 when the rate was well over 2%. It is obviously impossible to achieve so large a further reduction given the lower bound. Yet advocates of forward guidance criticize the FOMCs effort. They really couldn’t achieve as much again as has happened already (which past decline might not be due to forward guidance).

Another way to look at it is to try to guess about expected short term rates given the medium term rate (5 years as the limit of conceivably credible pre-commitment). A way to summarize the information is to imagine a forecast of 0 until t then normal short term rates from then on. The normal rate must be over 2% — no one can imagine policy setting interest rates below the target inflation rate indefinitely. The yield curve slopes up (on average) although there is no decade long upward trend in short rates, so it is normal to assume a risk premium in 5 year rates. Set it to zero.

Conveniently with miniscule interest rates over short periods of time compounding is almost exactly summing. So the duration of the period of 2% in the next 5 years in the just to summarize calculation is 2% is 0.66*5/2 = 20 months. The duration of the period of expected 0 rates is 3 years and 4 months. Bond traders seem to expect essentially zero short term rates through December 2015.

Importantly the FOMC predicts (not promises predicts) extremely low rates through 2014. It seems to me that bond traders take their prediction as a promise and then add a year. I don’t see how a cross my heart and hope to die and if I break my world all may know I am no gentleman promise could work any better.

Good beginning effort…

this of course is what every interest rate (Eurodollar and OIS) trader and hedge fund does explicitly every morning… but

The strength of Woodfords paper is that is adapts entirely the market mechanism as his explanatory variable

We hactually have traded instruments and indeed the most liquid instruments [look up Midcurve Gold Eurodollar options]

which are precisely what Woodford’s next paper will be about.. and which are everyone’s current research benchmark..

This are “bets” on where short term rates will be in 2016..but bets that settle every month

Woodford’s paper as well as much of his earlier work.. really is a “simple” attempt to work out the consequences (epistemological not economic) of the Law of Iterated Expectations.

Looking forward.. market yields and market “bets”… are really more akin to the Monty Hall paradigm..

(with Mr. Bernanke as Monty)..

When Ben finds out what the correct door is and stops being random … tell us whether we have to switch doors or not…