Minneapolis Fed President Kocherlakota disagreed with the new forward guidance the FOMC issued at its March 2014 meeting because the guidance creates macroeconomic uncertainty. In his opinion, the Fed could have actually reduced this uncertainty by being clearer about the kinds of labor market and inflation conditions that are likely to lead to an increase in the Fed funds rate.
The FOMC’s March 19 press release stated, “To support continued progress toward maximum employment and price stability, the committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 0.25% target range for the Federal funds rate, the committee will assess progress—both realized and expected—toward its objectives of maximum employment and 2 % inflation.”
The above statement talks about assessing progress towards maximum employment and 2% inflation but doesn’t explicitly state when or under what thresholds the Fed intends to raise its Fed funds rate. So stakeholders who make their personal consumption, business, and investment decisions based on expectations of when interest rates will rise are left uncertain.
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 they generally do well during the early part of tightening cycles.
To counter the uncertainty, Kocherlakota suggests an alternative: “The committee anticipates keeping the Fed funds rate in its current range at least until the unemployment rate has fallen below 5.5%, as long as the one-to-two-year-ahead outlook for PCE inflation remains below 2.25%, longer-term inflation expectations remain well-anchored, and possible risks to financial stability remain well-contained.”
This alternative guidance communicates the committee’s willingness to use monetary policy tools to push inflation back up to 2%. It reduces macroeconomic uncertainty by clarifying the kinds of labor market and inflation conditions likely lead to an increase in the Fed funds rate. It also deals with the unlikely possibility of risks to financial stability through an explicit escape clause.
Though, for the most part, Kocherlakota didn’t find the FOMC’s new forward guidance justified, he did endorse the fact that the report outlines the committee’s intentions for the Fed funds rate. Find out more in the next part of this series.
© 2013 Market Realist, Inc.