Thresholds versus Triggers

Fed Chair nominee Janet Yellen believes that the Fed will keep rates at zero long after the 6.5 unemployment threshold, according to news reports.  Yellen made the comments responding to an inquiry by Massachusetts Senator Elizabeth Warren about monetary policy. The question then is what does this threshold mean and how credible is it.

Here is the key line in what Yellen wrote Warren: “Monetary policy is likely to remain highly accommodative long after one of the economic thresholds for the federal funds rate has been crossed.”

At present, the Fed has two thresholds, one for unemployment and one for inflation. The unemployment threshold is 6.5% and the inflation threshold is 2.5%. I assume that Yellen said policy will remain accommodatve even after one of the thresholds is met because the Fed has an accommodative bias and will need to see both thresholds hit in order to trigger an interest rate hike. But more importantly, her response highlights the Fed’s thinking about its thresholds. In her response to Warren, Yellen also wrote  that ”it is also important to note that the thresholds are not triggers – that is, once a threshold has been crossed, the (Fed’s policy-setting) committee will not necessarily raise the federal funds rate target immediately.

See, this is the wiggle room the Fed has built in to its forward guidance. The difference between a trigger and a threshold is that a trigger would mean an automatic and mandated response from the Fed. So if inflation rose to the 2.5% target, it would trigger a rate hike. But a threshold is a softer form of guidance. It basically sets the pain threshold for the Fed. If the unemployment rate goes lower than 6.5%, the Fed can relax its accommodative bias and start thinking of raising rates. It will not even think about raising rates before then. But at 6.5% unemployment, it will begin that process, raising rates based on the overall macro picture.

So, what the Fed has done here is say that it remains committed to its dual employment/inflation mandate and it has set specific guidelines with each of its two mandates for when it will flip from its present accommodative stance to a tightening bias. Reaching the threshold for one will trigger a move to tightening, while reaching the threshold for both will ostensibly trigger an actual rate hike.

I find this communication of Fed policy very problematic.

Forward guidance is all about limiting future policy options in order to credibly communicate what future Fed policy will be. The Fed is supposed to be telling markets, “Look, we are proactively restricting our policy options in order to give you, the market a more precise feel for what we are going to do. We know that we need to both limit the scope of future policy and and then also follow through on our promises if our guidance about future actions is going to be credible enough to have an impact on long-term rates.” But now the Fed is cheating.

The Fed is panicked that it has set too high a bar and that the economy is worse off than it thought. When Bernanke just mentioned that the Fed was considering tapering, markets panicked and yields backed up so much that the economy started to backslide. This was a rude awakening for a Fed set on moving away from QE toward guidance as a tool. Therefore, the Fed has started to build the intellectual case for altering its initial guidance. That’s what the Wilcox and English papers were about. And this is what Yellen’s comments about thresholds versus triggers are all about. I understand the differences between thresholds and triggers but the Fed’s highlighting them only highlights the Fed’s incentive to cheat, to renege on its promises if the data are worse or better than expected.

Maybe forward guidance will be everything QE was not and the Fed will gain better control over expected rates. But this talk of thresholds and triggers and the Fed’s desire to move the goalposts to a new lower unemployment rate of 5.5% doesn’t make me comfortable. The Fed is just making this up as it goes along, hoping it makes as few mistakes that derail the recovery as possible.