The Federal Reserve is lending financial markets an ear - albeit cautiously - about the potential impact of unconventional monetary policy tools that it may use in the next economic downturn.
Fed officials acknowledged Friday that new policies deployed around the world, such as negative interest rates and yield curve control, are raising questions about possible distortions in financial conditions.
At the core of the debate: whether or not market expectations drive Fed policy or the other way around. Former Fed Chairman Ben Bernanke described the dilemma as a “hall of mirrors,” in which policymakers read asset prices while simultaneously trying to guide markets on future moves.
“We have to be open to the possibility that the markets’ view may be more in alignment with fundamentals than the policymakers’ view,” Cleveland Fed President Loretta Mester said at an academic conference in New York hosted by the University of Chicago.
Fed Vice Chairman Richard Clarida said he watches a few markets, such as interest rate derivatives and Treasury inflation-protected securities (TIPS), to get a read on market expectations.
But Clarida says he also pays close attention to surveys of expected inflation to baseline whether or not market-based measures are exaggerating term premiums.
“My colleagues and I do look at developments in asset markets, but never in isolation and always in the context of balancing asset market signals with complementary signals from surveys and econometric models,” Clarida said.
The “hall of mirrors” problem is confronting the Fed during its framework review, which the central bank plans on completing in the middle of this year.
Fed Governor Lael Brainard advocated for policies she would like to see the Fed embrace: a yield curve control policy that would cap short- and medium- term bond rates and an inflation-targeting strategy that would allow for flexible averaging.
Yield curve control would commit the Fed to purchasing Treasuries of both short-term and medium-term duration at whatever pace necessary to keep yields below a stated level. Flexible-average inflation targeting would allow the Fed to overshoot its 2% inflation target for a time to make up for periods during which the central bank undershot its target.
Brainard acknowledged that communicating these new tools would be critical to making them effective.
“To have the greatest effect, it will be important to communicate and explain the framework in advance so that the public anticipates the approach and takes it into account in their spending and investment decisions,” Brainard said.
But uncertainty about what these new policies would do to financial markets sparked debate at the conference over how carefully policymakers should trend when using these tools.
A conference paper entitled “Monetary Policy for the Next Recession” encouraged policymakers to be fearless in deploying those tools. The paper concluded that new monetary policy tools, ranging from negative interest rates to quantitative easing, did not appear to ease financial conditions overall. But the paper also noted that inflation risks also did not appear to materialize.
“We view the limited success in easing financial conditions in the face of global headwinds as a justification for more activist policy, not less,” the paper read.
The message: to launch those tools “early and aggressively” ahead of the next downturn.
Brian Cheung is a reporter covering the banking industry and the intersection of finance and policy for Yahoo Finance. You can follow him on Twitter @bcheungz.