Economists At The Cleveland Fed Have Found A Powerful Way To Augment Forward Guidance

Janet yellen
U.S. Federal Reserve Vice Chair Janet Yellen stands after testifying during a confirmation hearing on her nomination to be the next chairman of the U.S. Federal Reserve before the Senate Banking Committee in Washington, November 14, 2013. REUTERS/Joshua Roberts

One of the big questions that emerged from the
minutes of the Federal Open Market Committee’s October meetingwas how the Federal Reserve’s monetary policymaking body could reinforce the forward guidance it offers on the likely future path of short-term interest rates.

Current guidance dictates that the central bank will not raise the benchmark fed funds rate from its current target level between 0 and 0.25% until the unemployment rate falls below 6.5%.

Yet the Fed is also buying $US85 billion of bonds each month under its quantitative easing program, which the Committee would like to wind down soon in favour of relying more heavily on forward guidance to continue stimulating the economy.

Developments in recent FOMC communications have led Wall Street economists to predict that the Fed will look to augment its forward guidance around the time it begins tapering down its bond buying program in order to quell volatility in financial markets.

The latest minutes revealed, however, that the Committee hadn’t yet figured out at the time of its October meeting the best way to implement such a change.

A new analysis released today by economists at the Cleveland Fed suggests that adding a 1.75% inflation floor to the Fed’s 6.5% unemployment threshold would likely delay breaching of forward guidance thresholds by a year.

The basic finding of the study, according to Cleveland Fed vice president Edward S. Knotek II and senior economic research analyst Saeed Zaman
: “The joint probability of breaching either the unemployment threshold or the inflation threshold and at the same time satisfying the inflation floor first crosses 50 per cent by 2016:Q1, a four-quarter delay compared with the case without an inflation floor.”

“An inflation floor of 1.75 per cent could delay the point at which both the floor is satisfied and a threshold is crossed by about one year,” write the Cleveland Fed economists. “This exercise suggests that the choice of an inflation floor could exert a considerable delay on the liftoff of the federal funds rate from the zero lower bound.”

The option was discussed at the October FOMC meeting, according to the minutes, but the Committee was divided on the likely impact of such a measure.

“Participants also weighed the merits of stating that, even after the unemployment rate dropped below 6-1/2 per cent, the target for the federal funds rate would not be raised so long as the inflation rate was projected to run below a given level,” stated the minutes. “In general, the benefits of adding this kind of quantitative floor for inflation were viewed as uncertain and likely to be rather modest, and communicating it could present challenges, but a few participants remained favourably inclined toward it.”

Knotek II and Zaman say whether or not the FOMC adds an inflation floor to its suite of forward guidance, the “single most likely scenario” according to its forecasts is that the 6.5% unemployment rate threshold will be breached in the third quarter of 2015.