The Federal Open Market Committee’s (FOMC) announcement last month had two components: asset purchases and forward guidance on the federal funds rate. The large-scale asset purchase program (commonly called QE3) will be $85 billion per month in 2013 and remains open ended. FOMC said: “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability.” This guidance is qualitative; it depends on a general sense of the labor market, not a specific number. The Fed will look at various labor-market indicators and keep an eye on the inflation outlook.
Previously, the Fed stated a date through which conditions were expected to warrant exceptionally low levels of the overnight lending rate based on expected economic conditions. When the economic outlook changed, the date changed. Now, the Fed will simply list the economic thresholds. Specifically, the Fed indicated that it “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 6.5%; inflation between one and two years ahead is projected to be no more than a half percentage point above the [FOMC’s] 2% longer-run goal; and longer-term inflation expectations continue to be well anchored.” The unemployment and inflation thresholds are quantitative—that is, numeric. The 6.5% unemployment rate is a threshold, not a target, for when the Fed may start raising the overnight lending rate. It is a guidepost for policy, not a goal.
The unemployment goal (“full employment”) is currently seen in the 5.2% to 6.0% range. The Fed does not expect the unemployment rate to fall below 6.5% until 2015. The 2.5% inflation threshold may be interpreted as a short-term tolerance for higher inflation, not a target. Note that this threshold is based on the outlook for inflation one-to-two years out. The Fed is not going to react to current inflation. In their projections, Fed officials generally expect inflation to remain at or below the 2.0% target for the next few years.
As it is, the economic thresholds are currently equivalent to the recent date guidance (“mid-2015”), and the change in asset purchases is simply an extension of what the Fed decided in September. However, the expected date of policy tightening will depend on how the economy evolves. Faster job growth would pull that date forward. Weaker economic conditions would push the date out; long-term interest rates would fall accordingly, helping to stimulate growth. Thus, the threshold guidance should act as an automatic stabilizer for the economy.
In his recent press briefing, Chairman Ben S. Bernanke said that “by tying future monetary policy more explicitly to economic conditions, this formulation of our policy guidance should make monetary policy more transparent and predictable to the public.”
Scott J. Brown is senior vice-president and chief economist, Raymond James & Associates, Inc.