Kristina Hooper, CFP®, CIMA® is head of investment and client strategies for Allianz Global Investors Distributors LLC. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
The Federal Reserve is now using explicit economic targets—unemployment and inflation—to decide when to raise interest rates.
In a watershed moment for monetary policy, the Fed announced last week it is now pegging interest rates to a benchmark based on the percentage of people out of work. In a press release from the December Federal Open Market Committee meeting, the Fed said it will maintain artificially low interest rates as long as unemployment remains above 6.5%. Of course, that comes with a caveat: this scenario holds as long as intermediate inflation remains at 2.5% or lower and longer-term inflation expectations remain “well-anchored.” Previously, Fed Chairman Ben Bernanke said the central bank was committed to keeping rates low until 2015 with monthly liquidity injections based on economic conditions.
It is important to note that these economic targets are not triggers. They are merely thresholds. The Fed can begin to raise rates if any of these three thresholds are met, but it would also consider a range of measures first. In addition, quantitative easing remains in place but more qualitatively driven and tied to broad-based labor market conditions. The Fed will have to look at a number of labor-market indicators (the unemployment rate, hours worked, non-farm payrolls and the participation rate) as a drop in unemployment can provide a false signal through a decline in the participation rate.
Nevertheless, the move marks the first time the US central bank has explicitly targeted unemployment and inflation. This historic decision was the culmination of a long journey. Federal Reserve Bank of Chicago President Charles Evans had campaigned for such a policy—something he called the “7-3 rule”—for more than two years, initially targeting a higher unemployment benchmark (7%) and a higher inflation target (3%) in order to trigger the end of low rates. Evans later modified his proposal to 6.5% unemployment and 2.5% inflation, but despite campaigning publicly he was unable to win over the majority of the FOMC.
However, Fed sentiment toward what I would call “outcome targeting” monetary policy gained momentum this summer at the Economic Policy Symposium in Jackson Hole, Wyo. Highly respected monetary-policy economist Michael Woodford presented a paper endorsing the concept of “nominal GDP targeting.” He called for a clear policy goal such as a certain level of nominal GDP growth rather than a time line in an effort to provide more transparency and make the policy more effective. Woodson argued that a pledge by the Fed to restore nominal GDP “to the trend path it had been on up until the fall of 2008” would “make it clear that policy will have to remain looser in the near term” than would otherwise be indicated by the Taylor rule.
The Taylor rule, a guideline for interest-rate manipulation introduced by Stanford economist John Taylor is a policy recommendation that the "real" short-term interest rate should be determined by three factors: (1) where actual inflation is (relative to where the Fed wants it to be), (2) how far employment is above or below what is considered full employment, and (3) what the level of the short-term interest rate is that would be most conducive to full employment.
The San Francisco Federal Reserve Bank explains that the rule “recommends a relatively high interest rate (that is, a "tight" monetary policy) when inflation is above its target or when the economy is above its full employment level, and a relatively low interest rate ("easy" monetary policy) in the opposite situations.” Woodford, mindful that a violation of the Taylor rule might cause concern, added that such outcome targeting monetary policy would need to reassure “that the unusually stimulative current policy stance does not imply any intention to tolerate continuing inflation above the Fed’s declared long-run inflation target.” In other words, we need to make sure all of this stimulus—the monetary equivalent of steroids—doesn’t create side effects such as high long-term inflation.
By targeting the two outcomes of unemployment at 6.5% or less and inflation at 2.5% or less, the Fed is able to achieve its dual goals, described by Chairman Bernanke in his Jackson Hole speech—in what seems to be his order of priority—as to “promote a return to maximum employment in the context of price stability.” By targeting unemployment and inflation rather than nominal GDP growth, the Fed is able to address concerns about inflation, which may be raised by any violation of the Taylor rule in the shorter term, as alluded to by Professor Woodford.
This is one of the most drastic changes to monetary policy in the Fed’s 99-year history. While Bernanke has ushered in an era of transparency for the FOMC that had never been seen before, the explicit targeting of outcomes is arguably an even larger change. Rather than say the Fed will probably hold rates at current levels until 2015, the current rate is explicitly tied to unemployment and inflation. This approach is more logical and provides the transparency and greater certainty that investors appreciate. As a result, the market should be better equipped to price in rate increases. In reality, though, it probably won’t change much in terms of timing—at least this time around. In looking at the most recent three economic recoveries, the average time it took for unemployment to fall from 7.7%, our current level, to 6.5%, was 26.6 months.
There’s definitely more clarity around the Fed’s decision making now than ever. The question is, will outcome targeting really change the outcome?
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