The deflationary forward guidance threshold

In September I wrote that I expected the Fed to establish a lower bound for its inflation threshold as one of its next moves. The rationale was two-fold. First, inflation is undershooting and the Fed needs policy space to deal with unwanted disinflation. Second, a deflationary threshold would give wiggle room that the unemployment rate threshold does not. According to the Wall Street Journal this idea is in play at the Fed.

Here’s what the Wall Street Journal’s Jon Hilsenrath writes:

The Fed has said for months it won’t raise short-term interest rates from near zero until the unemployment rate, which was 7.3% in October, falls below 6.5%, as long as inflation doesn’t move above 2.5%. Fed officials believe the promise, known as “forward guidance,” helps hold down long-term borrowing rates, which in turn encourages borrowing, investment and spending.

There are several ways they could strengthen their message. One idea under discussion is to lower that unemployment threshold from 6.5%, which could mean keeping rates down longer. Fed staff research suggests the economy and job market might grow faster, without much additional risk of inflation, if the Fed promised to keep rates near zero until the unemployment rate gets as low as 5.5%. Goldman Sachs economists predict the Fed will lower the threshold to 6% as early as December and reduce the bond-buying program at the same time. 

Minutes of recent Fed meetings show officials have been debating the idea for several months and recent comments by officials show it is in the mix of discussions ahead of the Fed’s next policy meeting on Dec. 17 and 18, though such a move may or may not happen then.

“The labor market remains disturbingly weak. The good news is that, with low inflation, the [Fed] has considerable monetary-policy capacity at its disposal with which to address this problem,” Narayana Kocherlakota, Minneapolis Fed president, said in a speech earlier this week. He has advocated reducing the threshold to 5.5%.

Some Fed officials believe adjustments to the threshold are needed because the unemployment rate might be overstating the improvement in the labor market. The rate has been falling in part because people have been leaving the labor force, and hence no longer being counted as unemployed, a sign of labor market weakness, not strength.

Not everybody is sold on the idea and Mr. Bernanke could have trouble forging a consensus on the matter and on how to explain such a move. Achieving consensus is important in this case because broad support would help assure the Fed will stick to its promises in the long run.

Some of the Fed’s policy “hawks” worry its easy-money policies could cause inflation or another bubble. Officials also worry they might lose credibility with the public by shifting the threshold around.

Other Fed officials note they have already said the 6.5% threshold only starts the discussion on raising rates and doesn’t necessarily set rate hikes in motion. They have also noted rates might stay low for even after that mark is hit. “I’m not sure in this circumstance that changing the language from 6.5 to a lower number would actually tell people, on its own, anything different than we’re saying now,” John Williams, president of the San Francisco Fed, said in a meeting with reporters earlier this month.

One idea is to leave the threshold in place, but keep a guidance shift in reserve in case the economy stumbles and bond-buying programs are deemed no longer effective for addressing the problem. Under that approach, the Fed would be shifting its emphasis from bond buying to forward guidance as its preferred tool for responding to disappointments in the economy.

Another way to strengthen the commitment would be to reassure the public that rate increases would come slowly even after the 6.5% threshold is crossed, and another to signal the Fed won’t raise rates if inflation falls below some threshold like 1.5%.

The basic problem with all this is one of time inconsistency, a topic I had planned to write about in tomorrow’s daily commentary. But events on the ground require me to say a bit about it here.

This is how I see the picture at the Fed.

Policy makers at the Fed believe the U.S. recovery is weak and are concerned that fiscal policy is making it weaker. As a result, they have made monetary policy more accommodative than they would have liked. Because the housing market is a key variable both in terms of bank balance sheet health and in terms of aggregate demand which can sustain growth, the Fed decided to buy both Treasurys and mortgage-backed securities in the last round of easing. But, at some juncture for reasons still left unexplained, the Fed began to back away from QE and is now preparing to taper its large scale asset purchase program.

The economic recovery remains weak. Thus, despite tapering QE, the Fed has decided to replace QE with forward guidance as a policy variable. The problem with tapering and moving to a forward guidance paradigm is that it signals policy normalization aka tightening. And so the markets sold off violently when tapering was first announced. Moreover, the Fed has boxed itself into a corner on forward guidance with a very specific 6.5% unemployment threshold before it begins to raise rates. Unemployment is dropping quickly because of a falling labor participation rate and inflation is decelerating. The adverse change in labor participation and disinflation have meant that the 6.5% threshold has become less accommodative than the Fed thought it would be when it announced it.

The Fed is loath to change the unemployment threshold because doing so would introduce time inconsistency into the picture at the worst moment. See, the markets sold off when the Fed even mentioned tapering. Afterwards Fed officials already tried to jawbone the market back up, saying that the Fed could raise or lower the pace of QE depending on the pace of recovery. These remarks were not well received. They confused the market and muddled the Fed’s communication strategy. It was clear that the markets did not like the concept of the Fed promising to do one thing and then backing out of it when the data changed. That’s ‘time inconsistent’ – the Fed says one thing, but does another if the situation suits it, making the Fed’s preferences inconsistent from one period to the next. This time inconsistency weakens the credibility of Fed communications, increasing the temptation of markets to disregard forward guidance altogether and simply front run the Fed.

So, the Fed has to figure this out if it wants forward guidance to work. One way to deal with the now problematic 6.5% threshold is to simply be inconsistent and downshift the threshold. A paper by Fed economist William English gives the intellectual and theoretical support for doing so. English suggests moving the threshold down to 5.5%. Another possibility is to set up another complimentary threshold that gives the Fed more wiggle room. And that’s where the deflationary threshold comes into play. What this threshold would do is give the Fed an out and at the same time allow the Fed to say it is using both its inflation and unemployment mandates as thresholds for unconventional policy.

It isn’t yet clear what the Fed will do. But if the Fed wants to be more clear and wants forward guidance to be effective, it should not arbitrarily change its thresholds. Instead, it should add complimentary thresholds; and this favours a deflation threshold for forward guidance.

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