The Federal Reserve adopted an innovative tactic in its latest Federal Open Market Committee report. Instead of merely identifying a target federal funds rate, or giving guidance that rates will remain low for a certain period of time, the Fed now specifically targeted both an unemployment rate and an inflation rate, and said that their interest rates would remain constant at near-zero until those targets get met. Here’s the key section:
To support continued progress toward maximum employment and price stability, the Committee expects 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. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent 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 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance.
This kind of specific rate targeting is known as the “Evans rule,” after Chicago Federal Reserve President Charles Evans. He suggested a higher threshold for inflation, at 3%, but an unemployment rate of 7%. Narayana Kocherlakota, the President of the Minneapolis Fed, modified this rule, drawing unemployment down to 5.5% but reducing the inflation threshold to 2.25%. So the Fed opted somewhere in the middle.
Inflation has basically been both a target and a ceiling for several years now, capped at 2%. So this idea that inflation can go a 1/2 point above that target is very new for the Fed, and should boost economic growth. As Matthew Yglesias notes, this modest change in tolerance for inflation could bring cash off the sidelines:
The higher inflation target makes cash-like safe liquid investments look slightly less reasonable than they did yesterday, while the faster real growth implied by the unemployment target makes real investments in increased capacity look better.
3% is better than 2.5%, and 4% is even better than that. But this modest shift will manage expectations in a way that the Fed hopes will increase economic activity. I don’t know that it would totally offset the kind of major fiscal retrenchment that Congress seems to be stumbling toward, but it’s definitely a sign that the Fed understands the problem of high unemployment and the slow recovery, and has decided to act. You can see this in their statement that “The Committee remains concerned that, without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.” Only one board member, Jeffrey Lacker of the Richmond Fed, opposed the changes.
Michael Woodford, the Columbia macro-economic professor who basically convinced the Fed to use forward guidance with specific targets, deserves at least the Time Man of the Year award for completely changing the way the Federal Reserve enacts monetary policy. Hopefully it works.