Qualitative editing

When you learn about the Federal Reserve in an introductory economics course, you’re told the central bank conducts monetary policy by buying and selling bonds. So a new student of economics could be forgiven for being confused by the reaction to this week’s meeting of the Federal Open Markets Committee, the Fed’s policymaking committee. No new purchases or sales of government bonds were announced. Rather the big news was the shuffling around of words. And at a deeper level, this proverbial new student should be confused because what this editing signaled is that it’s okay to raise interest rates next year even though inflation is not a serious threat and unemployment remains too high.

The statement released by the committee and Chairmen Janet Yellen’s press conference contained no news of an imminent increase in the federal funds rates. Instead, the committee changed the wording so the statement no longer stated that the committee would keep its interest target rate at 0 percent for a “considerable time.” Instead, the committee would be “patient” before starting to increase interest rates.

To an observer uninitiated in the verbal machinations of the Federal Reserve, the change in language might seem like a difference without a distinction. But as Tim Duy, an economist at the University of Oregon, argues, all the signs are now pointing toward an increase in interest rates somewhere in the middle of 2015.

Yellen has been at pains to emphasize that the FOMC’s future policy is data-dependent. If a global recession suddenly happens or if inflation suddenly spikes, monetary policy will change given the circumstances. But given the situation right now and the current trends, does the prospect of increasing interest rates in six or so months make sense?

The most common way to judge the Federal Reserve’s movements is to see how well it is fulfilling its dual mandate: price stability and promoting maximum employment. On the first front, the Fed has explicitly stated that it shoots for a 2 percent annual inflation rate. In other words, prices are stable, according to the Fed, if the price index for Personal Consumption Expenditures is expected to increase 2 percent every year. What’s interesting, or rather concerning, is that the economic projections released by the FOMC yesterday show the committee projecting inflation, based on its Personal Consumption Expenditures index, to be somewhere between 1.0 and 1.6 percent during 2015. To put it bluntly: the Fed is saying that it will raise interest rates while inflation is below its target.

The economic projections also contain the Fed’s projections for the unemployment rate. They show a central tendency for that rate of between 5.2 and 5.3 percent. That measure is close to many estimates of the natural rate of unemployment, also known as the non-accelerating inflation rate of unemployment. Yet the labor market remains very weak, as current employment-to-population rates are still relatively low and wages are not growing at a healthy rate.

And therein lies the puzzle: the Federal Reserve is projecting inflation to be below target while unemployment is at what some analysts think is its natural level. So, the Federal Open Market Committee seems willing to be happy with 5.2 percent unemployment rate while its inflation projections seem to indicate they could push unemployment even lower.

Letting unemployment remain higher than it could be would have real ramifications. The result will be slow wage growth and higher levels of income inequality. Those outcomes would be the price for an impatient return to normalcy.


December 19, 2014


Monetary Policy

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