The Fed Signals Its Dimmer Outlook
The Federal Open Market Committee (F.O.M.C.) took the unusual step on Aug. 9 of announcing a specific time horizon for its extraordinary level of policy accommodation. Conceding evidence of a slowdown in the recovery, the committee voted 7-3 to adopt language stating that its target for the fed funds rate will likely remain at “exceptionally low levels” for the next two years. The committee also reaffirmed its intention to reinvest principal payments on its enormous holdings of Treasuries and other securities.
A New Lever for Monetary Policy
Explaining the change in the time frame of its forward guidance language, the committee cited data showing that G.D.P. growth has fallen short of earlier expectations, as well as worsening labor market conditions and lackluster consumer-spending growth.
Overall, the committee’s updated semantics suggest they are concerned that the economy could slide back into a contractionary phase. Under normal circumstances, this scenario would prompt a lowering of the fed funds target rate. But this is not possible in the current context, with the target already set between 0 and 25 basis points. In effect, conventional monetary policy is constrained by the 0 lower bound on the federal funds rate itself.
Not able to drop rates, the Fed extended the window. Narayana Kocherlakota, president of the Minneapolis Fed, interprets the “extended period” language as indicating a three- to six-month window before the target rate might be adjusted upward. That is generally consistent with Fed Chairman Ben Bernanke’s explanation in June that an extended period is consistent with two or three meetings of the F.O.M.C. In this interpretation, the fine-tuning in the Fed’s language reflects a rather sharp adjustment in its policy position.
But of its various options, why did the committee opt to limit its discretion in the exercise of monetary policy over such a long period? Especially when other unconventional policy tools may offer greater flexibility? The Fed might deviate from its two-year window should market circumstances change, but it risks its credibility in doing so. In part, its choices may reflect that other policy levers are currently perceived as ineffective or, in some cases, politically undesirable to a degree that even the independent central bank is wary, given the current environment in Washington.
In fact, policy watchers are not all that surprised by the adjustment to the forward guidance. Fed Vice Chairman Janet Yellen hinted at the potential for such a move in a February speech at the University of Chicago’s U.S. Monetary Policy Forum:
“If financial market participants appeared to be expecting policy firming to begin somewhat sooner than policymakers considered desirable or appropriate under such circumstances, the language of the forward guidance could be adjusted to shift expectations toward the somewhat longer horizon … ”
As part of that same speech, Dr. Yellen presented simulation-based evidence that such a move could result in significantly more accommodative financial conditions, even without an actual adjustment in the target rate. That result, she explained, “would be associated with a lower trajectory for the unemployment rate … and a somewhat higher path of core inflation … ”(1)
Diminished Expectations and Differences of Opinion
In deviating from its prior language, the committee signaled its expectations that growth will remain weak over the next couple of years, even apart from the information contained in the latest economic data. Given its dual mandate to “foster maximum employment and price stability,” the committee’s current exercise of its power to support growth suggests it also has a very muted outlook for inflation. The medium-term commitment to policy accommodation would be impossible if the Fed believed inflationary pressures were set to rise over this time frame.
But the committee is not united in its view of the economic outlook. During a June speech at the annual meeting of the Society of Business Economists in London, Philadelphia Fed President Charles Plosser, one of last week’s dissenting voters, offered that he “see[s] the inflation risks in the U.S. as being clearly to the upside.” He went on to explain as follows:
“In an environment with very accommodative monetary policy, a key to keeping commodity price increases from passing through to other goods and services and creating more general inflation is to ensure that longer-run inflation expectations stay anchored … So it is somewhat troubling to me that expectations of inflation in the medium to longer term are moving up and down as much as they are. It suggests that the public and the markets may not have as much confidence in the Fed’s ability, or willingness, to deliver on its price stability mandate.”(2)
While Dr. Plosser’s comments were made in June, when the market seemed on steadier footing, his viewpoint still holds sway. In a statement released this past Friday, Minneapolis Fed President Narayana Kocherlakota, who also dissented, echoed Dr. Plosser’s comments, stating that “ … personal consumption expenditure (P.C.E.) inflation rose notably in the first half of 2011, whether or not one includes food and energy.”
We must be careful in drawing too much from market signals of inflation expectations. In a research paper released this week, New York Fed economists David Lucca and Ernst Schaumburg find that TIPS breakevens and inflation swaps are both noisy and “imperfect gauges of inflation expectations.”
In sum, the Fed has opted for an unconventional policy lever that it perceives as very low risk, in spite of the fact that it may limit policy flexibility over an unusually long period of time.
Under the circumstances, an adjustment to the forward guidance compares favorably with policy tools that would result in the further expansion of the Fed’s balance sheet. In taking its new course, policymakers have conceded their expectation that growth will be middling over the next two years and that as a result, inflationary pressures will remain subdued even as monetary policy remains extraordinarily accommodative.
If they are wrong and have to adjust course, the institution’s credibility may be impaired.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.
1. Janet L. Yellen, Unconventional Monetary Policy and Central Bank Communications, February 25, 2011, http://www.federalreserve.gov/newsevents/speech/yellen20110225a.htm.
2. Charles I. Plosser, The U.S. Economic Outlook and the Normalization of Monetary Policy, June 9, 2011, http://www.philadelphiafed.org/publications/speeches/plosser/2011/06-09-11_society-of-business-economists.cfm.