Fed Signals Move Toward Thresholds for Keeping Stimulus

By Joshua Zumbrun and Aki Ito - Oct 5, 2012 12:00 PM GMT+0800

The Federal Reserve signaled it’s moving toward linking its outlook for near-zero interest rates to specific economic conditions such as a decline in the unemployment rate.
The move would represent a shift from the Fed’s policy of tying low rates to the calendar. At its last meeting, the Federal Open Market Committee extended its time horizon at least through the middle of 2015 from late 2014, a decision that some policy makers said could be misinterpreted as a downgrade of their economic outlook, according to minutes of the Sept. 12-13 gathering.

“The benefit of some numerical guidelines or thresholds would be that people would really understand their intention of keeping rates low,” said James Hamilton, a professor of economics at the University of California at San Diego whose research on the effectiveness of alternative policy tools has been cited in Fed Chairman Ben S. Bernanke’s speeches.

Policy makers such as Charles Evans, the president of the Chicago Fed, have said the central bank should promise to keep rates low until the unemployment rate falls to 7 percent, so long as inflation does not breach 3 percent. Participants at last month’s meeting said such a strategy would give the Fed more flexibility to adjust to changing economic conditions, while saying it would be “challenging” to agree on specific thresholds, given a diversity of views.
“There’s disagreement about the specifics,” Hamilton said. “The devil’s in the details.”
St. Louis Fed President James Bullard said yesterday a numerical threshold for unemployment would limit the Fed’s leeway.

Bad Outcome

“This threshold thing is going to put the committee in more of a box,” he said to reporters after a speech in Memphis, Tennessee. “And I think it is going to be not a good outcome even from the point of view of the people who want to do it.”

Stocks rose yesterday, sending the Standard & Poor’s 500 Index higher for a fourth day, after the European Central Bank said it stands ready to buy bonds, easing concern about the debt crisis that the Fed has identified as one of the main risks to the outlook for the U.S. economy.
The S&P 500 increased 0.7 percent to 1,461.40. The index has climbed more than 16 percent this year and remains near a four-year closing high of 1,465.77 reached the day after the Fed announced a third round of quantitative easing on Sept. 13.

Policy makers last month also said they could change the size of the central bank’s monthly asset purchases to reduce the risks associated with the program, such as disrupting financial markets and spurring inflation, the minutes showed.

Policy Costs

“Most participants thought these risks could be managed since the committee could make adjustments to its purchases, as needed, in response to economic developments or to changes in its assessment of their efficacy and costs,” the minutes showed.
The Fed is buying $40 billion of mortgage-backed securities a month as it seeks to boost growth and reduce unemployment stuck above 8 percent since February 2009. For the first time, the Fed didn’t specify the duration of the program.

While reducing borrowing costs, the Fed hasn’t made steady progress toward meeting its mandate to achieve full employment. A report from the Labor Department today is likely to show the jobless rate rose to 8.2 percent in September from 8.1 percent in August, according to the median forecast in a Bloomberg News survey of economists. The figures are due at 8:30 a.m. in Washington.
The Fed embarked on asset purchases to push down long-term borrowing costs after cutting its key interest rate to zero in December 2008. The Fed then added communications to its easing tools, linking its low-rate outlook to a specific date.

Economic Thresholds

Some officials have started questioning the strategy in public remarks, suggesting instead that the Fed tie interest rates to economic thresholds.
Yesterday’s announcement “confirms the sense that the committee continues to move toward numerical guidelines and thresholds for rate hikes,” said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York and a former researcher for the Fed Board in Washington.

Minneapolis Fed President Narayana Kocherlakota last month proposed holding rates near zero until unemployment falls below 5.5 percent, so long as the outlook for inflation does not breach 2.25 percent. Under such a proposal, the Fed might not raise rates for four years or more, he said.

Automatic Response

Agreeing on details may prove difficult. Some officials said that providing thresholds may be “too simple to fully capture the complexities of the economy and the policy process or could be incorrectly interpreted as triggers prompting an automatic policy response,” the minutes show.
Most U.S. central bankers “thought that further work would be needed to address the related communications challenges,” according to the minutes.

Bernanke said in an Oct. 1 speech in Indianapolis that forecasting the main interest rate will remain near zero until mid-2015 “doesn’t mean that we expect the economy to be weak through” that date.
The minutes reiterated that theme, saying central bankers wanted to clarify that holding interest rates low “did not reflect an expectation that the economy would remain weak, but rather reflected the committee’s intention to support a stronger economic recovery.”

The Fed’s current strategy came up for discussion at the Kansas City Fed’s Economic Policy Symposium in Jackson Hole, Wyoming last month, when Columbia University Professor Michael Woodford presented a paper in front of Bernanke and a group of about 120 central bankers, academics and journalists.

‘Reflect Pessimism’

Pledging to hold interest rates lower for longer could “reflect pessimism about the speed of the economy’s recovery,” Woodford wrote. “A more useful form of forward guidance, I believe, would be one that emphasizes the target criterion that will be used to determine when it is appropriate to raise the federal funds rate target above its current level, rather than estimates of the ‘lift-off’ date.”
The minutes also said policy makers conducted their second experiment on building a “consensus forecast” that would show how the diverse views of the Fed’s 12 regional presidents and seven Washington-based governors come together to form a single policy. They agreed to discuss the results further at their next meeting on Oct. 23-24.

To contact the reporters on this story: Joshua Zumbrun in Washington at jzumbrun@bloomberg.net
Aki Ito in San Francisco at aito16@bloomberg.net.
To contact the editor responsible for this story: Chris Wellisz at cwellisz@bloomberg.net