Photo: AP/J. Scott Applewhite
Low inflation and full employment have been statutory goals of the Federal Reserve since 1977, but its officials always felt more comfortable with the first than the second.After all, in theory monetary policy can’t alter unemployment in the long run.
But the stubbornly weak economy of recent years prompted some at the Fed to question their historical neglect of the second half of their mandate.
“The Fed’s dual mandate … has the force of law behind it,” Charlie Evans, president of the Federal Reserve Bank of Chicago, said in September, 2011. “So, if 5% inflation would have our hair on fire, so should 9% unemployment.”
Mr Evans argued the Fed should make it clear that unemployment and inflation both carried weight in its decisions by setting thresholds for both that would trigger a policy response.
This meant the Fed would explicitly tolerate inflation higher than its target if it wasn’t satisfied with the state of unemployment. He suggested 7% on unemployment and 3% on inflation, in other words the Fed would not tighten until unemployment was below 7% or inflation above 3%.
Mr Evans’ argument was so powerful because it called on the Fed to do nothing more than apply orthodox economic policy reasoning to Section 2A of the Federal Reserve Act. It was also a little bit subversive: Mr Evans’ rule was a sort of watered-down nominal GDP targeting.
But the Evans rule was much easier for the Fed to swallow than NGDP targeting because it required no radical remake of its operating framework.
By the conservative standards of the Fed, the Evans rule migrated with remarkable speed from the periphery to the mainstream. Colleagues as ideologically diverse as Janet Yellen, the dovish vice-chairman, and Narayana Kocherlakota, the hawkish Minneapolis Fed president, embraced it.
And today it became official Fed policy. Its policy panel, the Federal Open Market Committee, announced it would hold interest rates close to zero until unemployment had fallen at least to 6.5% from its current 7.7%, or inflation was forecast to top 2.5%. It’s now 1.6% excluding food and energy; the Fed’s target is 2%.
Previously, the Fed had promised to keep rates near zero until mid-2015. Fed officials still think that’s the earliest they’ll tighten, but feel more comfortable tying that decision to the state of the economy than the calendar.
Ben Bernanke, the chairman, said the Fed is not claiming any influence over long-term unemployment:
Our 6.5% threshold is not a target. What it is, is a guidepost [to] when the beginning of the reduction of accommodation could begin. It could be later than that, but at least by that time, no earlier than that time. So it’s really more like a reaction function or a Taylor rule, if you will — I’m ready to get the phone call from John Taylor. It is not a Taylor rule, but it has the same feature that it [says] how our policy will evolve over time as the economy evolves.
I think he understates things. If thresholds were simply another way to express the liftoff date for the Fed funds rate, it really wouldn’t be a big deal. But set against several steps taken earlier this year, it’s actually a fundamental repositioning of how the Fed operates.
It began in January with its under-appreciated (and poorly advertised) “principles regarding its longer-run goals and monetary policy strategy” that for the first time explicitly articulated that unemployment and inflation would get equal consideration in deciding when and how much to adjust interest rates. In September came the operative application of this new framework: it announced it would buy $40 billion a month of mortgage backed securities by creating money (“quantitative easing”, or QE) until the labour market had improved “substantially.”
With the latest decision it has quantified “substantially.” What all these steps do is attempt to harness the public’s expectations to leverage the stimulative effect of monetary policy. If investors believe the Fed will tolerate inflation above target, they will drive long-term interest rates lower even in the face of inflationary pressure. If the public believes the Fed is serious about unemployment, they will spend and invest more, helping to bring lower unemployment about.
There are risks. One is that the Fed may be putting too much faith in the reliability of the unemployment rate. It may think the natural unemployment rate is lower than it is, and in trying to push unemployment below that natural rate, drive up inflation – exactly the error it made in the 1970s.
By setting a current unemployment threshold and a projected inflation threshhold (specifically, the FOMC has to expect inflation to top 2.5% in one to two years), it aggravates that risk, since the FOMC will not be inclined to forecast inflation above its own target. In the opposite direction, the unemployment rate may overstate the economy’s strength, as its strangely rapid descent in the last year seems to do, triggering a premature tightening.
In truth, though, I think those are pretty minor risks. A much bigger risk is that for all the theoretical appeal of the Evans rule, it is not at all clear the Fed’s tools can deliver the lower unemployment it wants. If the public shares that scepticism, the expectations effect won’t work.
The Fed did say it would step up QE to $85 billion a month; Operation Twist, under which $45 billion of long-term Treasurys were bought in exchange for short-term paper each month, will be replaced by $45 billion of Treasury purchases, financed by printing money. But will those bond purchases do much good? The quick rally and reversal in equity markets is not encouraging. It may be, of course, that the new threshholds don’t change the path of tightening already discounted in the market. Or it may be, as Mohamed El-Erian writes:
Consider … the competing emotions a patient feels when confronted with news of a new drug that is yet to go through clinical testing. Professional investors welcomed the news that the Fed is “all in” when it comes to trying new drugs to stimulate the economy. And they fully understand that the transmission mechanism runs right through the equity markets.
As Bernanke has stated, the Fed is looking to “push investors to take more risks.” Hence the initial positive reaction to the announcement… As the day proceeded, investors realised that, like any experimental drug, there is a material risk of complications. After all, the Fed’s operational modalities are not straightforward; the analytical underpinnings are far from robust; and the Fed’s prior experimental measures have not succeeded in generating sustainable growth
Outsiders aren’t the only ones wondering about the efficacy of more QE. Jeremy Stein, a Fed governor, recently made the unsettling case that at least for business, Treasury purchases have no impact whatsoever on spending intentions (though the effect on households through mortgage purchases could still be quite strong).
Mr Bernanke seemed to have doubts of his own. Asked what more the Fed could do once the balance sheet, now just under $3 trillion, reaches $4 trillion, he replied:
It’s always possible we can find new ways to provide support for the economy. But it is certainly true that with interest rates near zero, and with the balance sheet already large, that the ability to provide additional accommodation is not unlimited.
That, actually, is an argument for being a little bit more aggressive now, to get the economy moving, to get some momentum. That protects the economy against unanticipated shocks that might occur and gets us off the zero-bound earlier.
In other words, the Fed should use lots of QE now, when it works, so that it doesn’t have to use more later, when it may not. This is not exactly the world’s most ringing endorsement of unconventional monetary policy. But it’s an honest one.
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