Federal Reserve Chairman Ben Bernanke delivered an excellent speech tonight; it is well worth the read. It reminded me that at least 75% of the Federal Reserve's communications problems would disappear if Bernanke had been willing to give a speech like this every two months. It is my hope that his successor Janet Yellen will deliver such speeches on a more regular basis.
There will be excellent coverage of the speech from the usual sources. So rather than a play-by-play review, I will focus on one topic, the unemployment threshold. There has been a great deal of speculation that the Fed will reduce the unemployment threshold to 5.5%. I have thought they will need to change the threshold because, at a minimum, the 6.5% number has already lost any operational meaning. But reading Bernanke's speech makes me think that they are very hesitant to change the threshold, and will instead continue to reinforce their existing forward guidance by emphasizing the likelihood that rates will remain low long after the threshold is breached.
Bernanke very clearly did not take this opportunity to hint that a change in the threshold was imminent. Instead, twice he reinforced the existing threshold. First:
In the judgment of the Committee, the unemployment rate--which, despite some drawbacks in this regard, is probably the best single summary indicator of the state of the labor market--is sufficient for defining the threshold given by the guidance. However, after the unemployment threshold is crossed, many other indicators become relevant to a comprehensive judgment of the health of the labor market, including such measures as payroll employment, labor force participation, and the rates of hiring and separation. In particular, even after unemployment drops below 6-1/2 percent, and so long as inflation remains well behaved, the Committee can be patient in seeking assurance that the labor market is sufficiently strong before considering any increase in its target for the federal funds rate.
And then later:
When, ultimately, asset purchases do slow, it will likely be because the economy has progressed sufficiently for the Committee to rely more heavily on its rate policies, the associated forward guidance, and its substantial continued holdings of securities to maintain progress toward maximum employment and to achieve price stability. In particular, the target for the federal funds rate is likely to remain near zero for a considerable time after the asset purchases end, perhaps well after the unemployment threshold is crossed and at least until the preponderance of the data supports the beginning of the removal of policy accommodation.
Note also that in a written response to Massachusetts Democratic Senator Elizabeth Warren and Louisiana Republican Senator David Vitter, Vice Chair Janet Yellen reiterated the same point. Via Reuters:
Warren asked in her letter if it would be helpful to lower the Fed's unemployment rate threshold - something that a number of economists, and some Fed officials, argue would be a potent way to do more to encourage consumer and business spending.
Yellen did not answer the question directly, but she repeated the Fed's talking point that the threshold was not a trigger for action, and rates could stay lower for longer.
"Monetary policy is likely to remain highly accommodative long after one of the economic thresholds for the federal funds rate has been crossed," she said.
The Fed's cautious approach of thresholds reflects a very real concern about the message a change would send. Jon Hilsenrath reveals this is the topic of active debate at the Fed because shifting the unemployment target could be considered a shift in the Fed's reaction function. Not everyone on the FOMC is comfortable with such a shift.
Hilsenrath describes the first line of thought at the Fed:
One line of thought is that the jobless rate is currently understating weakness in the job market because so many people are leaving the labor force. Under this view, there is much more slack in the job market than is indicated by 7.3% unemployment because millions of Americans are sitting on the sidelines, waiting to rejoin the job search process once opportunities become available. As this thinking goes, lowering the threshold to a number like 6% would bring the threshold better in line with the realities of the job market. It would be more a technical adjustment than a change in policy meant to add new stimulus to the economy.
This tends to be how I think of the issue - the 6.5% threshold is essentially irrelevant given economic conditions will induce the Fed to keep rates low long after the labor market crosses that threshold. Changing the threshold thus just brings the Fed's statement in line with reality. As Andy Harless reminded me in comments, however, the irrelevance of the 6.5% threshold is not "obvious" to everyone. Thus arises the implication that pushing the threshold down is a shift in the Federal Rerserve's reaction function. Back to Hilsenrath:
The other line of thought is that lowering the threshold would be meant to add more stimulus to a slow-growing economy by demonstrating to the public that the Fed is committed to keeping short-term interest rates low for even longer than previously planned.
I discussed this last in an earlier post. Fed research suggests that shifting the unemployment rate threshold to 5.5% would push back the expected lift-off from the zero bound by one quarter. Not a big change (again, economic conditions would not warrant a change at the 6.5% threshold to begin with), but an easier policy nonetheless. The Fed very much needs to understand which message it wants to send before setting themselves up for what could be another communications snafu. Hence the hesitation to jump in and change the threshold. I expect the minutes will reveal this was again a topic of conversation at the last FOMC meeting.
I am beginning to believe that the Fed will resist changing the threshold as long as possible, instead relying on emphasizing the "threshold not trigger" element of the existing forward guidance. Changing the threshold itself would then be reserved to add additional accommodation, if necessary, after the tapering process begins.
The problem with this story, however, is this: What does the Federal Reserve do if they have not raised interest rates after the 6.5% threshold is breached? Doesn't the threshold then become irrelevant? Do they then jettison the threshold based guidance entirely, or instead shift the threshold to 5.5%? But why make the change at that point, when policymakers would be even less certain about the sustainability of near zero rates?
In short, this forward guidance stuff is complicated.
Bottom Line: The issue of the thresholds is a hot topic at the Fed, but there is hesitancy to pull the trigger on the option of changing the threshold. They are not yet ready to chance signaling a change in the reaction function. And given that unemployment remains well above the threshold, there is no rush to change the threshold as long as the market believes it is not a trigger. This seems to be a message Bernanke is sending in this speech.