Defining Bernanke's New Fed Target
With $40 billion in monthly asset purchases, the Federal Reserve's new open-ended program of quantitative easing is all about generating self-fulfilling expectations of economic growth.
By articulating a target based on an economic outcome rather than the position of a policy instrument, such as the money supply or an interest rate, the Fed made a historic shift in its approach to monetary policy. Explicit targeting of an economic outcome channels monetary policy directly into expectations.
Many Fed watchers say the change in direction is unfinished. Though the Fed has tied policy to progress in the labor market, the target itself remains unclear. (In the press conference following the statement's release, Fed Chairman Ben Bernanke only said the weak average rate of hiring over the last six months "isn't it.")
"There's not a specific number we have in mind," Bernanke said. "We at least at this point have decided to define it qualitatively. I hope I am giving you at least a little color in terms of what we will be looking for. . . . We don't have a single number that captures that."
The next step is for the Fed to more clearly define its target, and it appears it may do just that in future FOMC meetings. "Working with our communications tools, clarifying our response to economic conditions, might be one way in which we could further provide accommodation," Bernanke said.
What would a better defined target look like?
Bentley University economist Scott Sumner, who had championed rule-based monetary easing in line with the Fed's action, would like the Fed to target nominal income along a level path. That would provide stable expectations and prevent the economy from being jostled by shocks to aggregate demand.
At least in the short run, Sumner's full proposal is unlikely to be realized. The Fed has taken a major step toward targeting an economic outcome -- in this case, increases in hiring that drive down unemployment amid a context of price stability. Another leap forward might be one change too many for the conservative central bank.
In addition to nominal gross domestic product targeting, the Fed has other paths to a clearer target. It could embrace the proposal of the president of the Federal Reserve Bank of Chicago, Charles Evans, by promising to continue easing until either unemployment falls below 7 percent or inflation rises above 3 percent. Economist Michael Woodford, who made a groundbreaking presentation about monetary policy at the zero lower bound of the nominal short-term interest rate at the Fed's conference in Jackson Hole, Wyo., has pushed for price-level targeting.
Much more likely is a definition of the Fed's policy target that is clarified in increments. There is a direct precedent for this: the Fed's introduction of forward guidance of when it would tighten policy. While the Fed first promised low interest rates "for some time" in December 2008, it later clarified its forward guidance -- first "for an extended period" in March 2009 and eventually with the time period, "at least mid-2013" in August 2011.
"For some time" is as vague a time frame as "ongoing sustained improvement" is a goal for labor market gains. This obscurity weakens the potency of expectations-based monetary policy.
What seems most likely -- and most similar to the evolution of forward guidance -- is that the Fed will reapply its economic projections as policy targets. This could happen twice every quarter as it forecasts growth of real GDP, the unemployment rate, and headline and core PCE over the next three years.
With this strategy, the FOMC could say that it views these projections as generally consistent with the qualitative economic outcome it desires. (It should further affirm that it considers a wider set of data in monetary policy decisions.)
The Fed, in essence, would "target the forecast" by using monetary policy to pursue these objectives in a balanced way. If the FOMC feared the economy was too weak to meet its forecasts for real GDP growth and unemployment, then it could ease policy until it kept reality on track with forecasts. If it suspected rising inflation, it could tighten until it was assured that its public forecasts would be roughly in line with the actual outcome.
Unlike fully-fledged policy rules, this commitment is necessarily looser, encompassing forecasted indicators and the intention to consider others. Yet it is an eminently plausible baby step for the Fed, and the approach has the advantage of familiarity. The Fed already publishes these forecasts. Nor would it have to scrap its inflation target for something wholly new.
It would also resolve Bernanke's concerns with setting quantitative targets as NGDP or the price level. The marginal specificity and clarity they provide come only at a severe cost, he fears: missing the desire for broad economic strengthening.
Reapplying its existing panel of forecasts with the caveat of qualitative consideration of other indicators may allow the Fed to get the best of both worlds: forecasts with numbers but without narrowness.
(Evan Soltas is a contributor to the Ticker. Follow him on Twitter.)
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