Academic Sways Central Bankers

Academic Sways Central Bankers

By KRISTINA PETERSON

While the markets and media focus on Federal Reserve Chairman Ben Bernanke, the economists and central bankers gathering in Jackson Hole, Wyo., also will be watching another speaker who is less famous than the Fed chief but highly influential.

ColumbiaUniversity

Mr. Woodford's views on signaling interestrate policy aren't without controversy.

ColumbiaUniversity economics professor Michael Woodford has urged Mr. Bernanke to make stronger commitments to keep interest rates very low for a long time. Mr. Woodford is scheduled to present a paper Friday at the Fed's annual retreat, focusing on the most pressing question Federal Reserve policy makers face: How to boost a weak economy when interest rates are near zero.

His paper won't be released publicly until Friday morning, but Mr. Woodford's thinking on the subject has influenced central bankers' policy decisions for years.

Typically, the Fed cuts interest rates to make borrowing cheaper and spur economic growth, and then raises rates as the economy gains steam to prevent inflation from taking off. But since the Fed cut short-term interest rates to near zero in late 2008, it has had to use other tools to try to spur the recovery (USE THE CRUISE SHIP ANALOGY)

Mr. Woodford's research suggests one way central bankers can spur growth is by spelling out that they plan to keep their benchmark short-term interest rate, the federal funds rate, very low even after growth starts picking up. That should help prevent long-term rates from rising and encourage households and businesses to borrow, spend and invest sooner rather than later.

"An important dimension that could still be used is giving clear signals about the nature of future policy," Mr. Woodford said in a recent interview.

Mr. Woodford's push to clearly delineate the path of interest rates has gained traction at some central banks.

"A lot of the way the Fed has behaved in terms of managing expectations about the future path of the [federal] funds rate—the foundations of that you can find in his work," said New York University economics professor Mark Gertler.

Since January, Fed officials have said they expect to keep short-term interest rates near zero at least through late 2014. Minutes of their July 31-Aug. 1 policy meeting show they considered saying rates would stay low for longer, or "even as the recovery progressed." Some favored describing specific measures of progress the economy would have to meet before the Fed would start raising rates. The officials deferred a decision on the matter until their next meeting, on Sept. 12 and 13 (LONG TERM INTEREST RATES (THE MOST IMPORTANT INTEREST RATE) ARE THE AVERAGE OF THE CURRENT AND EXPECTED PATH OF SHORT RATES - SEE BELOW:

i10 = [i1 + i12e + i13e + i14e + i15e + i16e + i17e + i18e + i19e + i110e] /10

EXPLAIN NOTATION

In words: Interest rate on long bond = average short rates expected to occur over life of long bond

"The issue of management of expectations is very central right now," said former Fed Gov. Frederic Mishkin, now a professor at ColumbiaUniversity's Graduate School of Business.

CLICK HERE FOR FOMC PAGE AND HERE FOR THE MOST RECENT STATEMENT

Charles Evans, president of the Federal Reserve Bank of Chicago, said he has looked to Mr. Woodford for insight into how the Fed should manage its public communications. Mr. Evans said his own views have "many things in common with Mike's analysis" that the Fed needs to commit to keeping rates low to get the economy going.

Mr. Woodford's views aren't without controversy. Some economists say the Fed stoked the housing bubble in the 2000s with its promises to keep rates low.

Some Fed officials today are dubious of such declarations. Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, has repeatedly voted against such statements. After the Fed's most recent meeting he said the Fed's assurance that it will hold rates down through 2014 "implies more confidence about the persistence of low interest rates than I believe is justified by the current outlook." TWO IMPORTANT ISSUES: 1) IF YOU COMMIT TO RATES THAT LOW, FOR THAT LONG, DOESN'T THAT SEND A SIGNAL THAT THE FED EXPECTS THE ECONOMY TO BE SO WEAK THAT THE ZERO BOUND IS APPROPRIATE FOR THIS LONG - NOT A POSITIVE SIGNAL AT ALL - MIGHT RESULT IN NEGATIVE ANIMAL SPIRITS - WE HAVE HAD ENOUGH OF THAT ALL READY AND 2) SUPPOSE OTHERWISE, AND THE FED ENDS UP BUMPING RATES UP BEFORE THEIR PROMISED AND COMMITTED TO DATE - THIS WOULD JEOPARDIZE THE FED'S CREDIBILITY. ESTABLISHING AND MAINTAINING CREDIBILITY IS SO IMPORTANT FOR CENTRAL BANKS AND SUCCESSFUL MONETARY POLICY.

Mr. Woodford made a research presentation directly to several D.C. Fed officials and their staff in Washington in the spring of 2003, when U.S. central bankers were nervously mulling whether cutting their key short-term rate below 1.25% could lead to deflation, a damaging fall in the overall price level.

In June 2003, the Fed, led by then-Chairman Alan Greenspan, cut the federal-funds rate to 1%. At its subsequent meeting in August, the Fed left the rate unchanged but stated that it would remain low "for a considerable period."

Members of the Fed's policy committee had split over whether to include the phrase, with Mr. Bernanke, then a member of the Board of Governors, urging others to include it. "I would appeal to the Committee to retain the sentence because in my view it makes a very big difference," Mr. Bernanke said, suggesting the Fed could "fine-tune" its communications in the future, according to the meeting's transcript. "Particularly near the zero bound, it could become an important part of our tool kit."

CLICK HERE FOR THE JUNE 2003 STATEMENT AND HERE FOR THE AUGUST 2003 STATEMENT

Mr. Woodford earned his B.A. in economics at the University of Chicago, a J.D. at YaleUniversity and his Ph.D. in Economics at the Massachusetts Institute of Technology. Mr. Woodford has known Mr. Bernanke for years. They both taught economics at PrincetonUniversity in the 1990s.

But he also has been critical of the Fed chief. Mr. Woodford wrote in a Financial Times opinion piece a year ago that the Fed needs to be less vague in its communications about the path of interest rates. That would help the economy more than a third major round of bond-buying, he wrote.

Write to Kristina Peterson at

A version of this article appeared August 31, 2012, on page A2 in the U.S. edition of The Wall Street Journal, with the headline: Academic Sways Central Bankers.