Why the FOMC’s new guidance suppresses economic activity
Another reason for Minneapolis Fed president Narayana Kocherlakota’s dissent to the FOMC’s statement was his stance on the uncertainty of what defines the “maximum employment level” for the U.S. economy.
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The unemployment threshold
The unemployment threshold is a form of forward guidance intended to help keep policy straightforward by assuring investors that rates will stay low until the economy improves. In December 2012, the FOMC said it would hold the target interest rate near zero—at least as long as unemployment remained above 6.5% and forecasts for inflation didn’t climb above 2.5%.
At their March 2014 meeting, Federal Reserve policymakers indicated that, in determining how long they should maintain the current 0%-to-0.25% target range for the Federal funds rate, they’ll assess progress—both realized and expected—toward their objectives of maximum employment and 2 % inflation.
Kocherlakota pointed out that the FOMC has provided little information about its desired rate of progress toward maximum employment in its forward guidance.
So, from its previous forward guidance strategy, the Fed is now seen to take a qualitative guidance approach, through which it might be less specific about economic targets. Accordingly, the Fed has decided to replace the 6.5% unemployment rate threshold with a qualitative guidance under the veil of maximum employment. These omissions create uncertainty about the extent to which the committee is willing to use monetary stimulus to foster faster growth.
Uncertainty could suppress economic activity
Clear communication is always important in central banking, and it’s especially important in the present circumstances, when the economy requires further policy stimulus but the traditional tool of monetary policy, the target for the Federal funds rate, is already effectively as low as it can go. Through its forward guidance, the FOMC provides an indication to households, businesses, and investors about the stance of monetary policy expected to prevail in the future.
An increase in the Fed funds rate has a ripple effect throughout the economy. This generally sends bond prices lower, since the fixed coupon rate they offer becomes less attractive relative to new issues at higher rates. ETFs like the ProShares Short 20+ Year Treasury (TBF), the HOLDRS Merrill Lynch Pharmaceutical (PPH), and the Vanguard Information Tech ETF (VGT)—which has its major holdings in information technology companies like Apple Inc. (AAPL) and Google Inc. (GOOG)—could help investors, as these generally do well during the early part of tightening cycles.
However, with quantitative estimates being replaced by qualitative guidance, the economy and its stakeholders are left guessing about what monetary policy could bring in the future. This uncertainty could be a drag on economic activity.
Kocherlakota suggested an alternative form of guidance that could have provided some direction in terms of indicating the timing and course of the Fed funds rate and the triggers it’s based on. Find out more in the next part of this series.