Data Thresholds Prompt Flexible Policy Expectations, Fed Says

Linking the Federal Reserve’s zero interest rate policy to economic data, rather than a calendar date, prompts investors to adjust their expectations for policy to changes in the economy, according to a Federal Reserve Bank of New York study.

“By specifying economic conditions rather than a calendar date, the central bank allows the market to determine the expected duration of the zero-bound policy based on its evolving view about the economic recovery,” according to the paper on the New York Fed’s website, which was co-authored by Katherine Femia, Steven Friedman and Brian Sack.

“If economic data or other information pointed to a weaker economic recovery and a slower decline in the unemployment rate, market participants would automatically extend the expected duration of the zero-rate policy, providing additional stimulus to help offset the weaker outlook,” the paper said.

The Federal Open Market Committee has said since December that it won’t consider raising the main interest rate as long as joblessness exceeds 6.5 percent and the outlook for inflation is no higher than 2.5 percent. The data thresholds replaced the Fed’s earlier plan to hold the benchmark interest rate near zero at least through the middle of 2015.

“If the ultimate objective of policy guidance is to provide information about the central bank’s policy reaction function, then the most direct approach is for the central bank to communicate directly about the economic conditions that are affecting the policy stance, rather than having investors make inference about those conditions from the use of calendar guidance,” the authors said in the paper dated this month.

Monetary Policy

Sack from 2009 until 2012 led the New York Fed’s markets group, which implements the central bank’s monetary policy. He is currently a co-director of global economics at D.E. Shaw & Co., a New York-based hedge fund.

William English, head of the Fed’s Division of Monetary Affairs, wrote in a separate paper that the strategy of not raising interest rates if unemployment is above 6.5 percent has provided effective stimulus, and that an even lower threshold could be helpful.

Chairman Ben S. Bernanke said Sept. 18 in Washington that “the first increases in short-term rates might not occur until the unemployment rate is considerably below 6.5 percent.” Joblessness was 7.2 percent in September.

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