There has been a huge, historic monetary policy statement from the Fed.
The Fed is now linking future monetary policy moves to hard economic thresholds on unemployment and inflation.
Previously, monetary policy has been at the Fed’s discretion, based on a subjective reading of unemployment, inflation, and economic data.
In the paragraph below, you’re reading the exact proposal put forth by Chicago Fed President Charlie Evans, who has long maintained that the Fed should promise not to tighten monetary policy until the economy hits specific economic thresholds.
In other words, rather than the Fed promising to keep rates low until 2015 (or some other arbitrary date) the promise is now to keep rates low until we’ve hit either 6.5 per cent unemployment or 2.5 per cent inflation.
The key paragraph:
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 per cent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 per cent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 per cent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labour market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 per cent.
When the Fed announced “QE open-ended” this summer, it was always clear that the Fed was going to start defining the key economic levels that it would look for in order to give the market a clear definition of when the economy was strong enough to stop loosening.
In our recent interview with Goldman’s chief economist Jan Hatzius, we asked him whether this was going to happen. He predicted that it would, but thought it would happen early next year, not at this Fed meeting. The fact that the Fed is going to hard thresholds now is definitely a surprise.
Here’s the key section from our interview with Hatzius:
BI: So in the meantime do you expect the Fed to adopt something close to an Evans Rule, where it’s not necessarily NGDP targeting, but where they’d get rid of the date-based targets and come up with some other threshold?
HATZIUS: That’s very much the signal that I would take away from what we’ve heard over the past couple of months. In particular, the speech by Janet Yellin the day before the last set of FOMC minutes – and it’s very much for the reasons that Woodford made out in his Jackson Hole paper – which is that they’re conceptually much happier with forward guidance that specifies how the economy performs as opposed to forward guidance that’s specified in the calendar.
So my expectation is that they will adopt an Evans-style rule or threshold guidance, probably not at the meeting next week, but I would expect it for sometime in the first quarter.
One thing I would say is I don’t think it’s a done deal yet.
While I expect it, I don’t think it’s a 90 or 95 per cent probability.
It’s still an ongoing discussion and there are a number of practical issues that have to be sorted out, one of which was illustrated in (Friday’s) employment report, namely the fact that the unemployment rate can fall for reasons that don’t really indicate a stronger labour market because of declines in labour force participation, which basically means the unemployment rate may not be such a good indicator of how the broad labour market is performing or how the overall economy is performing.
The less direct correspondence we have between where the unemployment rate is, ,what the overall economy is doing and what the overall labour market is doing, it gets trickier to adopt this sort of threshold guidance. Another issue is that I don’t think it’s clear how you would define the threshold guidance in terms of inflation. You don’t want to use headline inflation because it can move for spurious reasons like commodity shocks, which don’t really tell you what monetary policy should do.
On the other hand, the Fed has basically said in the minutes, that they don’t want to talk about core inflation anymore. They don’t want to talk about core inflation or even underlying inflation, and it’s sort of put a little bit of a shift in their position if they now specify the inflation threshold for tightening in terms of the core measure of inflation.
This has been a year of incredible evolution for the Fed, and this trend continued in its final meeting of the year.
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