The announcement by the US Federal Reserve Bank that it would link its monetary policy to the achievement of specific economic targets beyond inflation is a new development in its approach to policy.
In its statement, the Federal Open Market Committee said it had decided to:
“… keep the target range for the federal funds rate at 0 to ¼% and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-½%, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2% longer-run goal, and longer-term inflation expectations continue to be well anchored.”
While we have always known that the Fed looks at the overall state of the economy when setting policy, an explicit contingent rule is something new. To understand why the inclusion of specific thresholds for unemployment and inflation is so significant, we need to delve a little into US economic history.
In the 1970s, inflation in the United States was running at very high levels by the historical standards of the country. The average inflation CPI rate reached 11% in 1974, and US President Gerald Ford evoked wartime imagery in a speech on the topic:
Only two of my predecessors have come in person to call upon Congress for a declaration of war, and I shall not do that. But I say to you with all sincerity that our inflation, our public enemy number one, will, unless whipped, destroy our country, our homes, our liberties, our property, and finally our national pride, as surely as any well-armed wartime enemy.
His campaign was unsuccessful, however, and by 1980 the inflation rate was over 13%.
The problem with high inflation is that it can become something of a self-fulfilling prophesy. When workers are negotiating new wage contracts with companies, they will demand higher wages if they expect that inflation is going to be higher—and companies will be more willing to agree to those demands if they in turn expect to be able to sell their products for higher and higher prices. Meanwhile, managers setting those prices will anticipate higher wages, higher costs of materials, and higher prices by their competitors, and so be inclined to increase their own prices in line. Higher expectations of inflation lead to higher actual inflation.
It was in this context that President Jimmy Carter appointed Paul Volcker as Chairman of the Board of Governors of the Federal Reserve in August 1979. Volcker was determined to reduce the rate of inflation in the United States.
What he would have liked to do was to persuade people that the Fed was going to pursue policies that would bring down inflation. Had he been able to make that case to the American public, then expectations of inflation would have fallen, and actual inflation would have followed. The process would have been relatively painless. But expectations of high inflation were too firmly entrenched. When the Fed tightened monetary policy, the US economy went into a very deep recession. It took an economic environment of weak labour markets and declining demand for goods and services to induce workers to accept smaller wage increases and firms to set smaller price rises. By 1986, inflation was down under 2%. But to make this happen, the United States had had to endure the highest rate of unemployment since the Great Depression.
Having finally lowered inflation and inflation expectations, the Federal Reserve was determined not to let them get out of control again. In the quarter century since that time, US inflation has averaged 2.8% per year. The Fed had not only brought inflation under control, it had achieved the credibility as an inflation-fighter that it did not have when Paul Volcker took office.
But since the Global Financial Crisis, the Fed has faced a different problem. In its attempts to stimulate the sluggish economy it reduced its target interest rate (the Federal Funds rate) to 0 to 0.25%, and has kept it there ever since. It would almost certainly have liked to push the interest rate lower still, but it ran up against what economists call the zero lower bound. Essentially, it is not possible to push a dollar interest rate below zero. After all, the interest rate is the money a lender receives for extending a loan. A negative interest rate would mean that a lender was giving someone else dollars, and paying them for the privilege. But why would you do that when you can just keep the dollars? After all, dollar bills pay an interest rate of zero.
But there is a twist. The interest rate that matters to borrowers and lenders is the so-called real interest rate, which is the interest rate adjusted for expected inflation. If the nominal interest is zero, but the expected inflation rate is, say, 5%, then the true cost of borrowing is minus 5%.
At a negative real interest rate, households who wanted to borrow to buy houses, cars, or white goods would effectively be subsidised to do so. The same would be true for firms who wanted to invest in new plant and equipment. And this extra spending would stimulate the economy. So if the Fed were able to keep nominal interest rates at zero, while generating expectations of inflation, they could create the negative real interest rates that might be able to boost the economy.
This is the point, of course, where a quarter century of amassed credibility as inflation fighters became a liability. The Fed can indicate that it is willing to tolerate a bit more inflation, but people are understandably sceptical. They think that at the first sign of higher inflation, the Fed will revert to its now-established ways and put the monetary brakes on again. Recently, the Fed has tried to signal commitment to its policies through so-called “forward guidance” — statements that it was going to keep the Federal Funds rate low for a specified period of time. But today’s statement is a significant step further. It has now linked its policies explicitly to threshold levels of the unemployment rate and the inflation rate.
The Federal Open Market Committee is made up largely of Presidents of regional Federal Reserve Banks in the United States. The push to these explicit targets seems to have originated with the President of the Chicago Federal Reserve Bank, Charlie Evans. For example, in a speech in 2011 he said:
“One way to provide more accommodation would be to make a simple conditional statement of policy accommodation relative to our dual mandate responsibilities. The goal would be to enhance economic growth and employment while maintaining disciplined inflation performance. This conditionality could be conveyed by stating that we would hold the federal funds rate at extraordinarily low levels until the unemployment rate falls substantially, say from its current level of 9.1% to 7.5% or even 7%, as long as medium-term inflation stayed below 3%.”
Evans’ ideas got a big boost from President of the Minnesota Fed, Narayana Kocherlakota. Previously an inflation hawk on the committee, in a speech in September of this year Kocherlakota proposed:
“As long as the FOMC is continuing to satisfy its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5%.”
He also noted that: “Those familiar with [Charlie Evans’] plan will see that my thinking has been greatly influenced by his. This is perhaps hardly surprising, since he sits next to me at every FOMC meeting!”
The Fed’s new announcement tells us that Evans’ and Kocherlakota’s arguments have persuaded the rest of the FOMC. And though, like many Fed-watchers, I suspected this day would come, I am surprised at how quickly Evans' and Kocherlakota’s idea has turned into policy.
We will now sit back and watch to see if this new move by the Fed makes it clearer that it is as committed to bringing down unemployment as it is to keeping inflation under control.