Modern central banks have been described as “an army with only a signal corps.” It’s an apt portrayal.
The instrument that central banks most directly control -- the interest rate at which commercial banks lend to each other overnight -- affects virtually no transactions that most people care about. But expectations about the path of that rate shape long-term interest rates, which then influence economic activity. The signal that central banks send about this path is how they exert leverage over an economy.
Among the world’s central banks, the U.S. Federal Reserve’s signal corps has been the most active in sending out and refining its message. The logical next step is to specify numerical thresholds that will govern the Fed’s deliberations on the timing of its first rate increase since June 2006. More to the point, numerical thresholds will probably involve stating employment and inflation values that would need to be met before the Fed considers raising rates.
This is a worthy undertaking, but one that could take time to refine and put into practice. Fed governors have already started the discussion. Further progress at this week’s Federal Open Market Committee meeting would be a welcome development.
The Fed’s current calendar guidance -- that near-zero interest rates will likely be warranted at least through mid-2015 -- is the FOMC’s best estimate of what constitutes a “considerable period after the recovery strengthens.” This guidance communicates two things at once: the Fed’s economic forecast, and the expected policy response given that forecast.
Numerical thresholds downplay the first part, and instead focus on articulating with more specificity the second part -- the reaction to economic outcomes.
This should provide important benefits. Instead of breathlessly waiting on the Fed to alter its rate guidance, the market can automatically adjust its rate expectations in light of incoming economic data.
By focusing on how the Fed will react instead of what it forecasts, the tone of Fed communications should change for the better, too. Calendar guidance often risks sending a pessimistic signal about the Fed’s outlook for the economy. Communicating numerical thresholds, by contrast, would send a more affirmative message about the Fed’s commitment to full employment and price stability -- a message that should help bolster business and consumer confidence.
Make no mistake: The immediate benefit of establishing these thresholds would likely be minimal. After several fits and starts, the Fed has finally pushed back market expectations on the timing of the first post-crisis rate increase. In late 2009, even as the unemployment rate hovered at about 10 percent, markets were expecting the Fed to raise rates at least twice over the following year. Now, the Fed has convinced the market that the first tightening is at least three years away.
If the Fed says that rate increases won’t begin until unemployment is at least below 7 percent, that would likely do little to change market expectations on when short-term rates will rise and, hence, on longer-term rates. Instead, the benefits would slowly accrue over time. A more predictable, stable, rules-based policy framework should reduce uncertainty and prevent another situation like 2009 when interest rates moved at odds with the Fed’s mandated goals.
Operational hurdles remain. Take the example of Chicago Fed President Charles Evans’s “7/3” rule, which says the first rate hike won’t occur until the unemployment rate falls below 7 percent, provided inflation doesn’t get above 3 percent. There are still public misperceptions about what the 7 and the 3 really mean.
First, Evans has suggested that rates shouldn’t be raised before unemployment falls below 7 percent. After the surprise move down in the September unemployment rate, many analysts misinterpreted the 7 as a trigger rather than a minimally acceptable improvement in the labor market.
If unemployment falls below 7 percent (or whatever the threshold is) in a low-quality way -- because, say, people are dropping out of the labor force or more people are accepting part-time jobs -- there is no obligation for the Fed to raise rates. The Fed would need to emphasize that reaching an unemployment threshold is a necessary but not sufficient condition for tightening.
Second, Evans stipulated that 3 percent inflation should be considered a serious enough deviation from the Fed’s 2 percent inflation target that it should release the Fed from its commitment to keep rates low, even if the employment objective hasn’t yet been attained.
Regrettably, many have misinterpreted this to mean that Evans intends to raise the Fed’s inflation objective to 3 percent from 2 percent. The Fed must do a better job of spelling out the distinction between an inflation objective and a threshold that represents an intolerable deviation from that objective.
These are tactical issues. The strategic consideration, as it must be whenever a central bank is being innovative or aggressive in spurring growth, is inflation. The inherent conservatism of the Evans rule or similar thresholds is that they contain an automatic inflation firebreak. If structural unemployment is greater than anticipated, the ensuing wage and price inflation would activate the inflation circuit breaker and policy would be free to adjust.
Inflation, the greatest risk in a numerical threshold policy, would be inherently limited. Over time the benefits could be large, including more stable, predictable policy-setting that would automatically adjust to ensure interest rates are geared toward getting the economy back to work.
(Michael Feroli is the chief U.S. economist at JPMorgan Chase & Co. The opinions expressed are his own.)
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