A useful document in helping us understand what the FOMC is up to is the text of Bernanke's statement at the June press conference following the June FOMC meeting. This was the unusual case where Bernanke elaborated on the FOMC statement in a public forum, with the approval of the committee. If you read Bernanke's statement at the press conference, most of that is consistent with what the FOMC is thinking today, with at least one important exception, which relates to QE (quantitative easing). In particular, Bernanke said:
And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains, a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced this program.So, things did not evolve in the labor market quite as Bernanke expected. He was anticipating the beginning of tapering in the fall of this year, with asset purchases reduced to zero by about mid-2014, and the unemployment rate at about 7% by that date. Of course, here we are in December, tapering has not started, and the unemployment rate is already at 7%.
Given these past "commitments," one might think the FOMC would be eager to get the tapering show on the road, but apparently not. How come? There are two reasons. First, FOMC members appear to have decided that expressing forward guidance in terms of threshold values for the unemployment rate was a bad idea. You can see this in public statements by various Fed officials. For example, in this speech by Narayana Kocherlakota, he puts some effort into trying to convince us that the decline in the unemployment is not such great news, and that we should be focused on other measures of labor market activity, for example the employment/population ratio. In particular, he shows us this picture: this speech, but he's focused on this picture:
Second, the inflation rate has been falling since fall 2011, and is now well below the Fed's 2% inflation target:
So, what could be more obvious to a central banker? Inflation is below its target, the output gap is large, so we need more monetary stimulus, right? We can't get any more stimulus through conventional means, as the policy rate is currently essentially zero, so we should continue to use unconventional means - QE - which we are convinced works. Thus, no hurry to taper, right? And the Fed should continue emphasizing forward guidance, right? Wrong.
Kocherlakota in his speech, makes what I think is a bizarre argument, concluding with this statement:
These low levels of inflation show that the FOMC has a lot of room to provide much needed stimulus to the labor market.The argument is basically that the central bank always faces a Phillips curve tradeoff, and particularly in this case at the zero lower bound when only unconventional policy is available. Inflation is low, so we can get plenty of stimulus while remaining below the 2% inflation target, according to Kocherlakota.
But the falling inflation rate is actually a signal that the short run effects of past QE are gone, and that the effects of asset purchases get smaller the more you do it. Indeed, with the policy rate at the zero lower bound for more than five years now, no one should be surprised that inflation is low. But there are other voices on the FOMC arguing that continuation of QE at the current rate will make inflation higher than it would otherwise be, and make the "output gap" smaller. For example, in today's New York Times, I read:
“I don’t buy this diminishing returns thing,” James Bullard, president of the Federal Reserve Bank of St. Louis, said in an interview with Bloomberg Television last month. “If you lowered the funds rate from 5 percent to 4 percent, and then you lowered it from 4 percent to 3 percent, you probably wouldn’t say that the second hundred basis points was less effective than the first 100 basis points. And I don’t think we should say that about the Q.E. program either.”
What about forward guidance? The nature of that guidance has changed a lot over time. The FOMC started with "extended period" language in the FOMC statement. The fed funds target range was to stay at 0-0.25% for an extended period of time. Then, we were given more specific information. The fed funds rate was to stay low at least until some date in the future. Then that date was pushed further into the future. Then, a "threshold" was announced - the fed funds rate was to stay low at least until the unemployment rate fell below 6.5%. But now, it seems clear that 6.5% means nothing at all. The last FOMC statement from October says:
the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and 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 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.So now we have a whole lot of forward guidance. But what's it actually say? About as much as the FOMC would have said, or implied, before the financial crisis happened. They will look at everything, and then come to a decision. So, what was all that extended period/calendar date/threshold stuff about? What indeed?
The Fed has not been in a situation like this. They are making it up as they go along, and acting as if they know what they're doing. Now they're in a situation in which they're trapped by old thinking, and I don't think it's going to go well. So,
1. The FOMC needs to recognize that there is nothing more they can do that can affect real economic activity in the way they want while at the zero lower bound. The short run effects of unconventional monetary policy, to the extent that those effects are in fact quantitatively significant (which we really don't know), have played themselves out.
2. We're in a state where most of the forces at play look like they will tend to reduce the inflation rate over time if the policy rate stays effectively at the zero lower bound. Postponement of the "liftoff date," which looks like it could be in 2015 or later, only lengthens the period of time with inflation below the 2% target.
3. To get inflation up, the policy rate has to increase.