Behind the Fed's promise about short-term rates

Can promises about the future have an effect today? That's the theory behind the Federal Reserve's statement following Wednesday's monetary policy meeting.

The Fed said it "currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."

How is this supposed to work? How can a promise about the future course of interest rates have a stimulative effect on the economy today?

The answer begins with the recognition that any long-term bond, for example, a 10-year bond, can be duplicated with a series of short-term bonds, e.g. a series of 10 one-year bonds. Since the rates of return on these two different ways of accomplishing the same thing must equalize (otherwise an arbitrage opportunity would exist, and taking advantage of it would force the rates to be the same), if the Fed can lower rates on short-term bonds, then it can also effectively lower the rate on the corresponding long-term bonds.

Ideally, the Fed would like to lower today's long-term interest rates to stimulate business investment and mortgages (which depend on long rates more than short ones) by lowering the short-term rate it controls, the federal funds rate. However, it can't lower the federal funds rate any further because it's already at the zero lower bound.

But what the Fed can do is try to convince people that future short-term rates will be lower than they thought. If the Fed succeeds here, then it should be able get long-term rates to come down today. That's the purpose behind its promise to keep future short-term rates low, at the zero bound, long after they would normally be increased.

Whether this policy succeeds depends on if investors believe the Fed, how far the interest rates can move if they do believe, and how much business investment and housing respond to interest rate movements.

On all these fronts, we have reasons to be suspicious. First, the Fed has had a very difficult time changing expectations during the recession and recovery. Long-term inflationary expectations, for example, have hardly moved no matter what the Fed has said or done.

And even if the Fed does convince investors to change their expectations about future short rates, long-term rates don't have much room to move downward, so the effect would be small in any case.

Finally, there's reason to wonder just how much business investment and housing will respond to changes in rates given that economic outlook is still a bit weak and uncertain.

Nevertheless, the Fed believes it needs to do something even if the overall expected benefits are relatively small. And of course, not everyone on the rate-setting committee agrees. Charles Plosser, president of the Philadelphia Fed, dissented from Wednesday's policy decision because of this particular policy.