The Success of the Evans Rule and The Case For State-Based Quantitative Forward Guidance
Author: Skanda Amarnath & Sudiksha Joshi
While the Federal Reserve (Fed) cannot unilaterally deliver a swift recovery from the COVID-19 economic recession, it can still play a useful supporting role through its commitment to keep interest rates low. The Fed faces the same zero lower bound (ZLB) constraint that it faced in 2012, when it first decided to define its forward guidance policy for keeping interest rates low in terms of quantitative thresholds for economic indicators. At the December 2012 Federal Open Market Committee (FOMC) meeting, the Fed defined its commitment to zero interest rate policy (ZIRP) not in terms of a fixed calendar date but in terms of achieving specific macroeconomic benchmarks. In what is now known as the Evans Rule, the Fed committed to keeping interest rates low for as long as the unemployment rate remained above 6.5% and projections of inflation did not exceed 2.5%.
While the Evans Rule was not without its share of flaws, this quantitative state-based approach to forward guidance was a policy success. The commitment to keep interest rates low helped keep the economy afloat, despite headwinds from fiscal policy and household risk aversion. Future posts will discuss some of the flaws with and potential improvements to the Evans Rule that are relevant to our current context.
The Power of Forward Guidance: How The Fed Affects Interest Rates & Financial Conditions
The federal funds rate is the interest rate at which depository institutions lend and borrow reserves from each other on an unsecured basis. The Federal Reserve targets this interest rate through temporary and outright purchases of Treasury securities. By targeting the federal funds rate, the Fed manages to have comparable influence over other major short-term dollar-denominated interest rates as market participants seek to minimize arbitrage opportunities.
Yields on U.S. Treasury securities are especially sensitive to the expected path of the federal funds rate because the Federal Reserve conducts the vast majority of its open market operations through U.S. Treasury securities. 3-month Treasury yields closely track the interest rates on 3-month interest rate swaps that are indexed to each day’s federal funds rate.
While the federal funds rate directly affects other short-term interest rates, longer-term interest rates are more relevant for driving economic activity. The 30-year fixed rate mortgage is still the predominant financing vehicle for purchasing a home. Weighted average maturity of corporate bond issuance is typically over 15 years.
Yet changes in short-term interest rates do not automatically lead to consistent changes in long-term interest rates.
If the Fed signals that its change to the federal funds rate is a temporary measure to be reversed at a later date, then longer-term interest rates are less likely to change. In such instances, the yield curve steepens even when the Fed is cutting short-term interest rates. Likewise, the yield curve flattens (or even inverts) when the Fed raises short-term interest rates. Long-term interest rates can even move in the opposite direction of short-term rates if the market anticipates economic conditions that would motivate the Fed to ultimately reverse course.
As a result, the strength and credibility of the Fed’s guidance to market participants about the future path of the federal funds rate can be critical for influencing aggregate demand.
Conventional asset pricing theory tells us that long-term Treasury yields are largely a function of the expected path of short-term Treasury yields over the same time horizon, plus (or minus) an additional premium that compensates investors for the associated riskiness of holding higher duration Treasury securities. Since yields on short-term U.S. Treasury bills track the federal funds rate closely, market participants’ expectations for the future path of the federal funds rate should be reflected in yields on longer-term U.S. Treasury securities.
Forward guidance can help to clarify the expected path of short-term interest rates and limit the variance of potential outcomes in the process. If the Fed makes a credible commitment to maintain ZIRP for the next two years, then in the absence of any additional risk premium, 2-year U.S. Treasury Notes should also reflect the same ~0% yield as short-term Treasury Bills.
Now if 2-year U.S.Treasury Notes already reflected the expectation that the Fed would maintain ZIRP for two years, the Fed providing an explicit 2-year commitment to ZIRP would have very little additional effect. Moreover, calendar-based commitments do not provide additional clarity about the macroeconomic outcomes the Fed is seeking to achieve through ZIRP.
If the Fed could credibly commit to ZIRP as long as the unemployment rate remained above a specified level, then market participants would price ZIRP into the Treasury yield curve for as long as they expected the same outcome. If market participants later revised down their expectations of growth, market pricing would simultaneously adjust to reflect a longer timeline for ZIRP. As a result, there would be less of a need for the Fed to inject updated views about the expected timelines associated with their policies.
Theory vs. Practice — The Evolution of Forward Guidance Following The Great Recession
When the Federal Open Market Committee (FOMC) first voted to lower interest rates to the ZLB in December 2008, it signaled a qualitative calendar-based approach to forward guidance, committing to keep rates exceptionally low “for some time.” “For some time” soon morphed to “for an extended period” at the March 2009 FOMC meeting. Yet such guidance was largely meaningless because as soon as riskier assets formed a sustainable trough, markets began anticipating interest rate increases and Chair Bernanke was already willing to start advocate for fiscal tightening!
At the time that Chair Bernanke delivered those comments, job losses were still mounting and the Fed’s own projections of the unemployment rate suggested that interest rate increases would necessarily be much further out in time. In retrospect, this was a missed opportunity for pro-actively offering clearer forward guidance. Only at the August 2011 FOMC meeting, after the economy was already in the midst of a slowdown, did the Committee replace its vague qualitative guidance for calendar-based guidance by committing to keeping the federal funds rate near the ZLB “at least through mid-2013.”
The major problem with these forms of forward guidance was that it was unclear what objectives the Fed was ultimately seeking to achieve. In light of the risks posed by fiscal policy tightening and an ongoing set of sovereign debt crises in the Eurozone, the Fed was regularly forced to extend its timeline for ZIRP. It was far from clear to what extent the changes in calendar-based forward guidance reflected more ambitious policy objectives or simply a re-calibration of policy settings in response to negative economic developments.
Given The Circumstances, The Evans Rule Was A Success
Only in December 2012, amidst uncertainty about the paths fiscal policymakers might take, did the FOMC move away from calendar-based forward guidance and instead issue state-based forward guidance. At that meeting, the Fed defined the timeline for ZIRP according to quantitative economic thresholds:
These thresholds became known as the Evans Rule and served as the guide for Fed policy through to March of 2014, when the unemployment rate finally fell below 6.5%.
At first glance, it is tempting to say that this policy change did little to affect the trajectory of the US economy. The US economy grew slowly before, during, and after the period during which the Evans Rule was in effect. Moreover, communication errors and misperceptions about the Fed’s asset purchase policy in this period resulted in a historic bout of Treasury market volatility during the “taper tantrum.”
These points of skepticism have some validity but should not be lost in the broader context of the moment. Households were still working through a historic debt overhang with consumption growth still showing signs of lingering weakness. After years of historically low household saving rates in the late 1990s and the 2000s, the housing bust and Great Recession precipitated a rising propensity for households to save and strengthen their balance sheets. That said, the 2012 surge in the saving rate was the result of a temporary dynamic in which the fiscal cliff motivated the acceleration of dividend payouts that inflated measures of household income.
In addition to weak household consumption growth, the federal government was veering towards more fiscal austerity, hardly ideal when labor utilization is depressed and a private sector still deleveraging from the wounds of the housing bust and the Great Recession.
Despite all of these headwinds from late 2012 to early 2014, the US growth outlook somehow brightened. Though declining labor force participation exaggerated the effect, employment growth was nevertheless steady.
The core dynamic that shifted over this period was greater investment appetite within the corporate sector. Corporate credit and equity risk premiums continued to compress from late 2012 to mid-2014 in spite of the short-term surge in Treasury yields during the mid-2013 “taper tantrum.” The “taper tantrum” did reflect some excitement about the Fed ending its asset purchase policy sooner and possibly a faster liftoff from the ZLB, but at no point was it seriously expected that the Fed would make such an aggressive exit that it would jeopardize the objectives reflected in the Evans Rule.
While compressing corporate credit and equity risk premiums do not consistently lift growth and investment, in 2012–14, the upswing in business fixed investment was critical for offsetting aggregate demand headwinds.
Even though the Great Recession technically ended in 2009, the process of deleveraging within the household and financial sectors during and following the financial crisis meant that other sectors would need to carry the burden of generating sufficient aggregate demand. Yet with the fiscal cliff looming large at the end of 2012 and austerity policies already in train, the set of economic actors capable of supporting income growth within the rest of the economy was especially narrow. The US was closer recession than might otherwise be appreciated in retrospect. Fortunately, the non-financial corporate sector accelerated its rate of spending and investment to buffer the rest of the economy.
While the Evans Rule did not cause this outcome directly in the way that fiscal expansion could have, the Fed’s unconventional policies still helped to preserve the business cycle expansion amidst significant obstacles.
