Fed Is Shooting at a Moving Target
Tinkering around the edges. That’s how it strikes me, all this talk about adjusting thresholds and offering more and better forward guidance.
In the old days, the Federal Reserve had tools to fix what ailed the U.S. economy. Too much inflation? Raise the benchmark federal funds rate. Recession the problem? Lower the rate.
With the funds rate effectively at zero, these tools proved inadequate. The Fed turned to large-scale asset purchases, designed to lower long-term interest rates, and elevated forward guidance to a policy tool.
Forward guidance has a legitimate rationale. The long-term rate is the sum of the current and future expected short-term rates, plus a term premium for added interest-rate risk. If investors know the short-term rate will remain at zero until some future date or until certain goals are realized, the long rate will incorporate those assumptions.
There’s also an inherent flaw in the rationale. The Fed doesn’t know if it can deliver on its promise. Fed forecasts have been overly optimistic these past few years, and the Fed’s prediction that the subprime crisis would be “contained” was a world-class flub, especially for a central bank that doubles as a financial regulator.
That hasn’t stopped academic types from searching for a better mouse trap. The idea of lowering the Fed’s 6.5 percent unemployment threshold -- a prerequisite to considering a rate increase -- found renewed support in two papers presented at the International Monetary Fund’s Research Conference on Nov. 7-8. That the authors of both papers were high-level Fed staff members in Washington gave it added credence, prompting Goldman Sachs Group Inc. chief economist Jan Hatzius to predict a reduction to 6 percent at the December meeting.
One paper, “The Fed’s Framework for Monetary Policy -- Recent Changes and New Questions,” by William English, J. David Lopez-Salido and Robert J. Tetlow, argued for “threshold-based forward guidance.” The authors found that “reducing the unemployment threshold improves measured economic performance until the unemployment threshold reaches 5.5 percent.” In the model, that is.
The other paper, by David Wilcox, Dave Reifschneider and William L. Wascher, made the case for a “highly accommodative monetary policy” in the face of persistent economic slack and well-anchored inflation expectations.
A threshold is only as good as the sum of its moving parts. At his news conference in June, Fed chief Ben Bernanke said that if the economic data were consistent with the forecast, a tapering of monthly asset purchases could start “later this year.” Under that scenario, the end of the program would probably coincide with an unemployment rate of 7 percent, he said.
The unemployment rate fell to 7.2 percent in September, yet the Fed refrained from taking the first baby tapering step. The decline in the rate from its peak of 10 percent in 2009 is the result of more people dropping out of the labor force than finding a job. Economists can argue whether the cause is structural or cyclical, but the improvement in the labor market clearly didn’t live up to the Fed’s standards.
The Fed is struggling, grasping at straws, to find alternate ways to stimulate economic growth.
“They’re groping -- hopefully toward something more productive,” says David Beckworth, assistant professor of economics at Western Kentucky University in Bowling Green. “It’s troubling they are changing the threshold so often. That’s the problem with targeting a real variable,” such as employment.
Beckworth is among a group of economists who advocate nominal gross domestic product level targeting. Nominal GDP -- real GDP plus inflation -- already has the advantage of incorporating both of the Fed’s dual mandates: stable prices and full employment. The road to full employment goes through strong GDP growth.
If the Fed wants thresholds and forward guidance to act as a policy accelerator, it can’t keep changing them. Currently there are an array of suggestions on the table: lowering the unemployment threshold; targeting higher inflation; introducing an inflation floor; setting a fixed size or fixed date for the current open-ended bond-buying program; reducing the interest rate the Fed pays banks on their excess reserves; instituting new guideposts, such as linking a reduction in monthly purchases to a decrease in the unemployment rate; and probably more we haven’t heard about. (No one has suggested linking a reduction in quantitative easing to a certain percentage increase in the stock market just yet!)
“It looks as if they are making it up as they go along,” Beckworth says. Which they are.
Let’s face it: The Fed has never been very good at targeting anything except the funds rate. Remember those money-supply cones that had to be rebased every year? Inflation has been below the Fed’s 2 percent target for 19 months, yet the Fed has been unable to push it or will it up.
A moving threshold is like a moving target: The chances of hitting it are slim. But hey, even the blind squirrel gets lucky once in a while.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist.)
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