Fed’s Strategy – How to avoid having hands tied?

At its FOMC meeting, the Federal Reserve has kept unchanged its interest rates and has continued to reduce the amount of assets purchased every month. Nevertheless the monetary policy framework has changed. The reference to a threshold on unemployment rate to trigger a change or thinking to a change of interest rates has disappeared.

Three remarks on the economic situation
The main point is that the Fed considers that the weakness perceived in January and February was temporary,  due to adverse climate conditions. According to the US central bank, the underlying trend is robust. Economic activity will continue to increase rapidly.
The GDP forecasts show a 3.1% growth for 2014 versus 3.2% that were December’s forecasts (for every forecast I show the middle of the range published by the Federal Reserve). If there is a weakness during the first quarter, this means that the recovery in the following quarters will be strong (these figures compare GDP level for each year. The first quarter profile is very important.)

One immediate consequence of this robustness is that unemployment rate will continue to fall. For 2015, it should be at 5.75%.

The last point is that the Fed considers that risks on growth and on inflation are mostly balanced (probability of higher growth is matched by probability of lower growth). This means that it is not a specific and immediate risk that induces a accommodative monetary policy. The fed’s will here is to ease the convergence to a full employment trajectory.

Monetary Policy
As the underlying trend of the economy is robust, there is no reason to change the way monetary policy was put into place.
The reduction in financial asset purchases that has started last January will continue. At each meeting since December 2013, the amount purchased is reduced by USD 10bn. This will continue. In April, the amount will be USD 55bn (25 for MBS and 30 for Treasury securities). Until last December the amount purchased every month was USD 85bn.

But Fed’s interest rates will remain low in the range [0 – 0.25%] for long. Janet Yellen has mentioned a considerable period of time will be seen between the end of the asset purchases program and the increase of interest rates. (“The Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens”)

What has changed in the monetary policy framework is the disappearance of the forward guidance framework. At previous meetings, the Fed said that there were thresholds on unemployment rate and on expected inflation rate that would be a trigger on interest rates’ change. We’ve seen two steps
With unemployment rate at 6.5% and 1 or 2 year expected inflation rate at 2.5% (0.5% above the Fed’s 2% target), the fed was first supposed to change its interest rates. It was the first draft of forward guidance. The second draft was to say that unemployment rate had to be well below 6.5% to change interest rates.

Now these thresholds have disappeared at the March meeting.. The current unemployment rate (February) is at 6.7% which is very close to the 6.5% triggering level. The rapid convergence to 6.5% and the former framework were a constraint for the Fed. The disappearance of the forward guidance framework suggest that the Fed does not want to have its hands tied by a commitment that could limit its ability to satisfy its dual mandate on growth and on inflation.

The Fed will look at a large range of indicators on the labor market and on economic activity and inflation to determine its interest rates’ profile.

Median fed-fund interest rate is expected at 1% in 2015 (0.75% for December forecasts) and at 2.25% for 2016 (1.75% in December). During the press conference, Janet Yellen said there was no huge differences between December and March forecasts.
What we have to keep in mind is that long term fed-fund rate level is at 4%. In other words, in a well-functioning economy, the Fed interest rate should be at 4%, not at [0 – 0.25] the current range and not at 2.25% the level expected in 2016. The Fed considers that, in 2016, the economy will not have converged to its long-term full employment trajectory.

Final Remarks
The “considerable time” mentioned by Yellen is about 6 months according to her. In other words, if asset purchase stops at next fall, interest rates will increase during spring 2015. The delay is probably too short.
I think that the interpretation we must have of this new strategy is that the Fed doesn’t want to have its hands tied. By choosing more indicators to gauge the strength of the economy, the Fed wants to be able to choose the moment at which it will change its interest rates. Janet Yellen has created some uncertainty just to have more capability to decide.
Anyway, whatever the framework, Janet Yellen clearly wants to keep the yield curve low. It is a necessity to foster the recovery.

In other words, Janet Yellen probably doesn’t want a rapid increase in interest rates as far as the economy is still far from full employment and as inflation rate is well below Fed’s target of 2%. For Janet Yellen, the forward guidance framework was not the good one. She wanted to have more autonomy to decide on the moment where interest rates have to move on the upside.
Clearly, the Fed’s move is a setback for Forward Guidance. It’s amazing to see that in few weeks, the Bank of England and the Federal Reserve have given up this framework.
It’s also amazing to see that the economy has converged very rapidly to the defined profile associated with forward guidance. The unemployment rate at 7% was attained in January 2014 in the United Kingdom and the current unemployment rate of 6.7% in the USA is very close to the 6.5% threshold.
It would be interesting to know how those thresholds were defined. Is it just a kind of optimization from economists at the BoE or at the Fed or is it a more political target?

The last point to mention is to say that in her introduction, Janet Yellen told that an “inflation rate persistently below its target could pose risks to economic performance”. This means that central bankers have to be proactive in this situation, to reduce the persistency of this situation. Mario Draghi in the Euro Area only wants to know that at the end, inflation rate will converge to the 2% target. The monetary philosophy on the two sides of the Atlantic is not shared.

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