Strength in numbers? Pros and cons of Fed policy thresholds

November 20, 2012

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Federal Reserve policymakers are striving to find common ground as they consider whether to adopt specific numerical thresholds for inflation and joblessness as guideposts for U.S. monetary policy.

Many policymakers think doing so could help clarify how the timing of an interest-rate hike might change in response to shifts in the economic outlook. But others worry that using numerical thresholds could be confusing or misleading.

Arriving at a consensus on what milestones to use and how to communicate the shift away from the Fed’s current guidance that rates will stay low through at least mid-2015 is tricky. Just what are they discussing, and what are the challenges? Here are some key questions and answers:

DOESN’T THE FED ALREADY HAVE AN INFLATION TARGET?

The Fed is charged with both maximizing employment and keeping prices stable. The Fed never explicitly defined either of those goals until this past January, when for the first time it adopted an inflation target of 2 percent. A threshold, by contrast, is a tool for signaling a potential change in policy, and could be different from the long-run target. The Fed could pledge low rates until inflation breaches a particular threshold, at which point it would reconsider that policy.

WHAT ABOUT UNEMPLOYMENT?

The Fed has not adopted a target on the unemployment side. The reasons are two-fold: first, economists cannot agree on how low unemployment can go before wage-related price pressures start to build; second, the level could shift over time as the contours of the economy change. That makes it a challenge to choose a numerical threshold below which the Fed would consider tightening policy. Making things more difficult, the unemployment rate can rise or fall depending on whether people are entering or leaving the work force. Fed policymakers closely watch job gains and other measures of labor market health, and some have proposed using these markers in setting thresholds.

WHY NOT JUST PROVIDE A TIMEFRAME FOR HOW LONG A PARTICULAR POLICY WILL STAY IN PLACE?

That’s what the Fed has done for a several years now, and San Francisco Federal Reserve Bank President John Williams argues that the approach has been both simple and effective. Still, many officials, including Williams, would prefer to describe policy in terms of economic conditions rather than a date. Some worry that saying exceptionally low interest rates are “likely to be warranted at least through mid-2015″ sounds too much like a promise that rates will stay low for another three years, regardless of what happens in the economy. Pledging low interest rates until unemployment reaches a certain level, or inflation rises above a set pace, might let the Fed tailor policy better to changing economic conditions.

WHAT WOULD SUCH A POLICY LOOK LIKE?

Three top Fed officials have publicly touted versions of a threshold-based policy. Chicago Fed President Charles Evans has urged the Fed to pledge low rates until unemployment falls below 7 percent, as long as inflation does not threaten to rise above 3 percent. Minneapolis Fed President Narayana Kocherlakota has proposed keeping rates where they are as long as inflation stays between 1.75 percent and 2.25 percent, until the jobless rate reaches 5.5 percent, a level that many economists consider full employment. And Boston Fed President Eric Rosengren said that as long as inflation remains subdued he’d have the Fed buy assets until unemployment falls below 7.25 percent, and keep rates low until unemployment falls as low as 6.5 percent.

IF IT’S SUCH A GOOD IDEA, WHAT’S STOPPING THEM?

While many policymakers think moving to a numbers-based framework would be useful, it’s hard to find agreement on the numbers. How high above the Fed’s 2 percent goal is too high? A few tenths of a percentage point, as Kocherlakota argues? Or a full percentage point, as Evans does? With jobs, there are even more questions, since many policymakers view the unemployment rate as only a crude approximation of labor market health, and also watch job gains and other measures. Should the Fed use actual measurements of economic conditions or forecasts? Should it specify other conditions besides a set unemployment or inflation rate that might signal a change in rate policy? Policymakers also worry that guideposts could wrongly be interpreted as triggers for an automatic policy response, or that they might be confused with policymakers’ vision for long-term economic health. While Evans believes 7 percent unemployment is an appropriate threshold for rethinking policy, he also thinks unemployment should eventually be pushed much lower. Williams in October pitched keeping rates low until unemployment falls somewhat below 7 percent as long as inflation does not threaten to rise above 2.5 percent, but has more recently backed off that idea, saying he is worried that numerical thresholds are “hard to get right.”

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