Keep It Simple, Central Bankers
This week, the U.S. Federal Reserve and the Bank of England both made welcome moves toward more simplicity. Specifically, they recast the "forward guidance" they'd previously given investors about their intentions.
Both central banks have been surprised by unexpectedly rapid falls in unemployment. The Fed had previously promised not to start raising interest rates before unemployment in the U.S. had fallen to 6.5 percent. At 6.6 percent, it's almost there -- but the recovery is still weak and the Fed has no intention of raising rates for a good while yet. The Bank of England's unemployment threshold was 7 percent. That's probably already been reached, but the U.K. also will most likely need low interest rates for many months to come.
It was a mistake all along to make specific rates of unemployment "thresholds" for adjusting monetary policy. The state of the labor market is crucial for judging policy, but it isn't the only factor; in any case, the headline rate of unemployment doesn't accurately measure labor-market conditions. U.S. unemployment has fallen rapidly partly because workers are quitting the labor force, not just because they're getting jobs. There's plenty of room for the U.K.'s economy to grow, too, despite the unexpectedly rapid fall in unemployment.
In both countries, adding unemployment rates to the guidance was meant to support demand by convincing investors that interest rates would stay very low for longer. This was the right objective under the circumstances. Then the unemployment measure started getting smaller -- and investors began to get confused. Rather than clarify their guidance, thus making it even more complicated, new Fed Chairman Janet Yellen and the Bank of England's Mark Carney rightly chose to make it simpler.
Carney's new formulation omits the unemployment rate altogether, and he says instead that the Bank of England "will not take risks with the recovery." There's plenty of spare capacity, he said, and even when that starts to run out, the bank will raise rates slowly and cautiously. The bank also published more information on its economic forecasts than it has before, showing it currently expects rates to stay put until mid-2015.
Yellen wasn't quite so forthright in abandoning the Fed's unemployment threshold, but what she said amounts to the same thing. The fact that headline unemployment is close to 6.5 percent tells investors approximately nothing -- and that's official. She said the Fed is now looking beyond traditional measures of unemployment to judge the tightness of the labor market and detect any incipient pressure on inflation.
This new balance makes sense. Give investors more information and explain the thinking more fully -- but don't tie policy to specific indicators, and don't make promises (or seem to make promises) you don't intend to keep.
To contact the editor responsible for this article: David Shipley at email@example.com.