Fed Moves Toward Tying Interest-Rate Decisions to Economic Data

Fed Moves Toward Tying Interest-Rate Decisions to Economic Data
The Marriner S. Eccles Federal Reserve building stands in Washington, D.C., U.S. Photographer: Andrew Harrer/Bloomberg

The Federal Reserve is embarking on the next step in Chairman Ben S. Bernanke’s journey toward greater transparency -- tying its outlook for borrowing costs to measures of employment and inflation.

Policy makers “generally favored the use of economic variables” to provide guidance on the when they are likely to approve their first interest-rate increase since 2008, according to minutes of their Oct. 23-24 meeting released yesterday. Such measures might replace or supplement a calendar date, currently set at mid-2015.

A number of officials also said the Fed may need to expand its monthly purchases of bonds next year after the expiration of a program to extend the maturities of assets on its balance sheet, known as Operation Twist. The discussion indicates that Fed officials judge the economy still needs record stimulus to reduce an unemployment rate stuck near 8 percent.

“I just really don’t see how you’re going to get something that constitutes a substantial improvement in labor market conditions in the next month or so,” said Michael Hanson, senior U.S. economist at Bank of America Corp. in New York and a former Fed economist.

Hanson predicts the Fed will start buying about $45 billion a month in Treasuries next month, more than doubling the $40 billion of mortgage-backed securities the central bank is currently purchasing in its third round of quantitative easing.

Stocks Fall

The Standard & Poor’s 500 Index extended declines yesterday, falling 1.4 percent to 1,355.49 in New York, the lowest level since July, as concern about the budget debate in Washington and an Israeli air strike wiped out an early rally led by technology shares. The yield on the 10-year Treasury note was little changed at 1.59 percent.

The Fed didn’t set an end date for bond purchases in its Sept. 13 announcement. It said it would continue or increase them if the “outlook for the labor market does not improve substantially.”

San Francisco Fed President John Williams said yesterday the central bank will probably continue buying bonds “well into” the second half of next year to bring down U.S. unemployment now at 7.9 percent.

“I expect it will be some time until the job market makes substantial progress towards our congressionally-mandated maximum employment goal,” Williams said in a speech in San Francisco.

Additional purchases would be needed to replace Operation Twist, under which the Fed is swapping about $45 billion of short-term Treasuries on its balance sheet for longer-term debt. The program is set to end in December as the central bank will have nearly exhausted its holdings of short-term debt.

Harder Time

Officials are likely to have a harder time agreeing on changing their guidance on the outlook for interest rates, said Dean Maki, chief U.S. economist for Barclays Plc in New York. At its last meeting, the FOMC repeated that its key rate is likely to stay low at least until mid-2015.

“It’s possible that by a meeting early in 2013 they’ll have reached enough agreement to implement these measures” on tying the federal funds rate to economic thresholds, though such a move may not be “realistic” by the Fed’s next meeting in December.

Vice Chairman Janet Yellen this week endorsed the idea of tying rates to specific economic conditions. That concept has been pushed in recent speeches by Charles Evans, president of the Chicago Fed, and Narayana Kocherlakota of Minneapolis.

“Many participants were of the view that adopting quantitative thresholds could, under the right conditions, help the Committee more clearly communicate its thinking about how the likely timing of an eventual increase in the federal funds rate would shift in response to unanticipated changes in economic conditions and the outlook,” according to the minutes.

‘Qualitative’ Guidance

Officials disagreed on whether thresholds should be expressed in terms of a specific number, such as the unemployment rate, or a “qualitative” description. Several participants were concerned that using a number might confuse the public by giving the impression the Fed focuses on a small number of variables, the minutes showed.

Using a qualitative description also has drawbacks, Maki said. “If they say We’ll wait to tighten until the labor market is ‘strong,’ what does that mean exactly?” he said. “You need a quantitative threshold if it’s going to be meaningful.”

Officials have offered differing thresholds. Evans originated the idea of tying policy to numerical guideposts with a proposal to continue accommodation until unemployment falls to 7 percent so long as inflation does not breach 3 percent.

Kocherlakota’s Level

Kocherlakota has proposed holding rates near zero until unemployment hits 5.5 percent so long as the outlook for inflation remains below 2.25 percent.

Boston’s Eric Rosengren has proposed mixing the two approaches, with a quantitative goal of 6.5 percent unemployment so long as “inflationary pressures remain muted.”

Other “open questions” raised by the minutes include whether to use current or projected measures of economic activity, and whether to provide information about how quickly the central bank would raise interest rates when the time to tighten comes.

“When they actually sit down and try to get down to brass tacks, it may be much harder to develop a consensus on how to operationalize these ideas,” said Bank of America’s Hanson.

Bernanke Effort

The debate is part of Bernanke’s effort to bring more transparency to Fed deliberations. Officials say that greater public understanding makes their actions more potent because the economy is affected by expectations about the future policy.

Bernanke introduced a 2 percent inflation goal and started holding press conferences after every other meeting of the FOMC. The Fed has also started publishing policy makers’ forecasts for economic growth, unemployment, inflation and the future path of interest rates.

Fed officials hold their last meeting of the year on Dec. 11-12. That meeting will be accompanied with an update of FOMC participants’ economic forecasts and a press conference with Bernanke.

“It’s tricky to balance communications with credibility and accuracy,” said Garth Friesen, who helps oversee $2.1 billion as principal at III Associates, a Boca Raton, Florida-based hedge fund that invests in government bonds and credit derivatives. “To date they’ve done a pretty good job in a world where rates are already zero.”


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