Monday, March 17, 2014

A Short History & the Future of Forward Guidance
The FOMC will meet this week on Tuesday and Wednesday, March 18 and 19. The important question will be how the committee tweaks its forward guidance now that the unemployment rate was down to 6.7% during February, approaching the committee’s 6.5% threshold for discussing whether or not to start raising interest rates.

That threshold was first announced in the FOMC's December 12, 2012 statement, when the previous month's jobless rate was 7.8%. Prior to introducing this new “data-dependent” forward guidance for the federal funds rate, the statements were calendar based. Since August 9, 2011, they promised to peg the rate between zero and 0.25%, adding that the committee anticipates that “exceptionally low levels for the federal funds rate” are likely to be warranted for a specified period into the future. For example, the October 24, 2013 statement anticipated that the fed funds rate would remain near zero through mid-2015.

The statements from March 18, 2009 through June 22, 2011 used the phrase “extended period” rather than specifying a date in the future for keeping the federal funds rate near zero. The January 28, 2009 statement vaguely promised a near-zero federal funds rate “for some time.” Of course, in the previous December 16, 2008 statement, the FOMC announced that the federal funds rate had been lowered to a range of 0.0-0.25% for the first time without specifying how long it might remain there. (See our searchable archive of FOMC statements.)

The forward guidance issue was raised at the January 28-29 meeting this year, according to the minutes: “Participants agreed that, with the unemployment rate approaching 6-1/2 percent, it would soon be appropriate for the Committee to change its forward guidance in order to provide information about its decisions regarding the federal funds rate after that threshold was crossed.” Various views were expressed by the FOMC’s participants:

(1) Lower the unemployment rate threshold.Some participants favored quantitative guidance along the lines of the existing thresholds….” (Emphasis mine.)

(2) Adopt a qualitative rather than quantitative approach.[O]thers preferred a qualitative approach that would provide additional information regarding the factors that would guide the Committee's policy decisions.”

(3) Put more emphasis on financial stability.Several participants suggested that risks to financial stability should appear more explicitly in the list of factors that would guide decisions about the federal funds rate once the unemployment rate threshold is crossed….”

(4) Give more weight to inflation.[S]everal participants argued that the forward guidance should give greater emphasis to the Committee's willingness to keep rates low if inflation were to remain persistently below the Committee's 2 percent longer-run objective.”

(5) Get ready to increase the federal funds rate. “A few participants raised the possibility that it might be appropriate to increase the federal funds rate relatively soon.”

Of course, much depends on how the FOMC interprets the faster-than-expected decline in the unemployment rate. Recall that former Fed Chairman Ben Bernanke at his June 19, 2013 press conference said that the Fed would start tapering QE before the end of last year and would terminate the program by mid-2014, when the unemployment rate was expected to be down to 7.0%.

In their most recent statements, both Fed Chair Janet Yellen and FRB-NY President Bill Dudley said that they are still not satisfied with the progress in the labor market. The number of people working part-time for economic reasons and the number of long-term unemployed workers remain too high. In my opinion, the FOMC is likely to devise some new data-dependent rule to justify continuing NZIRP (near zero interest rate policy). They might lower the unemployment rate threshold to 5.5% and stress that inflation must rebound back to 2% before they’ll even consider raising rates.
(Based on an excerpt from YRI Morning Briefing)

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