What Picnics Say About Monetary Policy
Federal Reserve officials work very hard to ensure that their monetary policy choices are informed by the best possible evidence and theory. They could be a lot more effective, though, if they applied the same rigor to the way they communicate.
To grasp the importance of communication, consider a question I once posed to a group of high-school and college interns at the Minneapolis Fed. Suppose, when you were younger, your parents had said: “If it rains tomorrow, we’re not going to have a picnic.” What would you have expected if the sun came out the next day? The interns all responded that they would have expected a picnic.
The interns’ conclusion seems entirely natural, in the sense that it is logically consistent with the parents’ statement. But it is not logically necessary. The parents have communicated only what will happen if it rains. From a purely logical perspective, they are free to decide not to go on a picnic if the day turns out to be sunny. The children’s conflicting interpretation means that there will probably be some tears if the picnic doesn’t happen.
So what does this have to do with monetary policy? Consider a real-life example. In December 2012, with its interest-rate target already near zero, the policy-making Federal Open Market Committee stated that it “currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent.” (I’m leaving out some language about inflation that doesn’t matter for the point that I’m trying to make.)
Like the parents, the Fed was saying what would happen only in one possible future -- in which the unemployment rate exceeded 6.5 percent. It said nothing about what it intended to do once the unemployment rate fell below 6.5 percent, preferring to retain flexibility (see page five of then-Chairman Ben Bernanke’s news conference). But just like the children, many observers reached a much more specific conclusion: that the Fed would begin to raise rates if the unemployment rate fell below 6.5 percent. Again, this conclusion was consistent with the Fed’s limited communication, but it was not logically necessary.
The discrepancy meant that, at least metaphorically, tears were shed when the unemployment rate fell below 6.5 percent and the Fed didn’t raise rates. Many observers believed that the central bank had reneged on a promise. To this day, they point to this episode as a prime example of why the Fed’s statements should not be viewed as credible.
The picnic example suggests that the reaction to the “6.5 percent” communication should have been entirely predictable. Yet the field of macroeconomics -- and really economics as a whole -- has little to say about these kinds of regularities. Fortunately, other disciplines such as cognitive science, psychology and communication sciences have a lot more to offer. In hindsight, it seems that better knowledge of that research would have been useful for policy makers.
One highly studied framework in cognitive science, for example, treats people as using a "mental models" approach to reasoning. This means they organize and interpret facts using simplified models of how the world works -- models that have trouble making inferences that depend on something being false. This is exactly the kind of confusion that occurred in the two examples.
My own lesson from the reaction to the December 2012 statement is that the Fed needs to think more carefully about the way it communicates its plans and actions -- and that doing so will probably require it to broaden its intellectual reach.
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