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November 14, 2012

Janet Yellen’s Game-Changing Speech for Monetary Policy

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Janet Yellen, Vice Chair of the Board of Governors of the Federal Reserve System

The President opened his press conference by designating the top two priorities as jobs and growth, and then spent the next 60 minutes answering questions about David Petraeus and Susan Rice and tax rates and Benghazi and deficit reduction. And Obama didn’t seek to break out of that constraint and suggest actual near-term job creation strategies. So it’s pretty clear that jobs are a dead end as far as the legislative process is concerned.

On monetary policy, however, things have suddenly become a bit more promising. Janet Yellen, the Vice-Chair of the Federal Reserve, delivered a speech yesterday that strongly endorsed the idea of “forward guidance” in the economy, tying monetary policy actions to a specific employment target. The idea was first brooched by Charles Evans, the President of the Chicago Federal Reserve, who because of the rotation of regional Fed Presidents on the Federal Open Market Committee, will actually get a policymaking slot in 2013. Here’s the key part of what Yellen said:

The three elements of forward guidance that were adopted by the FOMC in September 2012 would have been unthinkable in 1992 and greatly surprising in 2002, but they have, in my view, become a centerpiece of appropriate monetary policy [...]

Another alternative that deserves serious consideration would be for the Committee to provide an explanation of how the calendar date guidance included in the statement–currently mid-2015–relates to the outlook for the economy, which can and surely will change over time. Going further, the Committee might eliminate the calendar date entirely and replace it with guidance on the economic conditions that would need to prevail before liftoff of the federal funds rate might be judged appropriate. Several of my FOMC colleagues have advocated such an approach, and I am also strongly supportive. The idea is to define a zone of combinations of the unemployment rate and inflation within which the FOMC would continue to hold the federal funds rate in its current, near-zero range. For example, Charles Evans, president of the Chicago Fed, suggests that the FOMC should commit to hold the federal funds rate in its current low range at least until unemployment has declined below 7 percent, provided that inflation over the medium term remains below 3 percent. Narayana Kocherlakota, president of the Minneapolis Fed, suggests thresholds of 5.5 percent for unemployment and 2.25 percent for the medium-term inflation outlook. Under such an approach, liftoff would not be automatic once a threshold is reached; that decision would require further Committee deliberation and judgment.

I support this approach because it would enable the public to immediately adjust its expectations concerning the timing of liftoff in response to new information affecting the economic outlook. This market response would serve as a kind of automatic stabilizer for the economy: Information suggesting a weaker outlook would automatically induce market participants to push out the anticipated date of tightening and vice versa.

Here’s some commentary on this from Matt Yglesias, Joe Weisenthal and Tim Duy. So the idea here is that the Fed does not set a date for the expiration of monetary stimulus, but a target unemployment rate. Therefore, the market knows that the loose policy will continue until the economy recovers, and particularly until the jobless rate recovers.

I think you can assume that Yellen wouldn’t go out on her own with this without some support from Ben Bernanke. Goldman Sachs, in a research note, thinks that this was a key signal that forward guidance will shift to outcomes in the near future, though in the near term this may only apply to the federal funds rate, rather than the $40 billion in monthly “quantitative easing” currently being carried out by the Fed.

As it turns out, we just got the minutes of the October FOMC meeting, and they also show discussion of this kind of outcomes-based approach. The policymakers listened to a staff discussion on the topic, and “participants generally favored the use of economic variables, in place of or in conjunction with a calendar date, in the Committee’s forward guidance, but they offered different views on whether quantitative or qualitative thresholds would be most effective.” So broad support of the concept, while some hesitancy on the details. But a newer, more dovish Fed in 2013 might leap at the idea, and hopefully they would view inflation higher than 2% as a target.

That would be good, because monetary policy seems to be faltering somewhat. Ryan Avent notes that inflation expectations, which he uses as a measure of economic strength, have collapsed since mid-October. This could be because of the fiscal slope hysteria, but it could signal a structurally weak economy that needs some support. This type of forward guidance is a bit untested, but anything that could shape expectations and boost the economy is positive.

Tim Duy does sound the right note here, however: what if the Fed has pulled the string?

I would add that Yellen’s speech did not even generate a knee-jerk response in the stock market today. I remember a time not long ago when any hint of dovishness was good for a 1% rally. Which, combined with Avent’s thoughts, leaves me wondering if open-ended QE is the last of the Fed’s monetary tools. We now know the Fed will continuously exchange cash for Treasury or mortgage bonds until the Fed’s economic objectives are met. Uncertainty about the course of monetary policy as been largely eliminated. There is not likely to be a premature policy reversal. What if the pace of the economy does not accelerate, sustaining a large, persistent output gap and a low inflation environment? The Fed could increase the pace of purchases, but would this really change expectations? Can we get more “open-ended?” [...]

“Open-ended” sounds much like “unlimited.” And unlimited sounds like the end of the road. If the economy stumbles, will the Fed pull a new trick out of its policy bag, or is that bag finally empty? And if that bag is empty, then we will need to turn to fiscal policy if the economy stumbles.

And given the mania to tighten fiscal policy rather than loosen it, that’s a bad road for the economy.

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