Geo-Graphics

In October 2012, the Fed issued what came to be called a “pledge” to keep its target interest rate near zero through mid-2015.  The market immediately reacted as the Fed wanted, centering expectations on a rate hike in mid-2015. At its next meeting, the Fed abandoned date-based guidance in favor of data-based guidance: a pledge to keep rates near zero until the unemployment rate fell below 6.5%.  The Fed emphasized, however, that the two pledges were consistent, as it didn’t expect unemployment to fall below that level until mid-2015. The Fed justified the shift from date-based to data-based guidance by stating that the latter “could help the public more readily understand how the likely timing of an eventual increase in the federal funds rate would shift in response to unanticipated changes in economic conditions and the outlook.” But has it? Fast forward, and the unemployment rate has been falling much faster than the Fed anticipated back then; the Fed now expects it to dip below 6.5% later this year.  Yet the market has revised its rate expectations in the opposite direction; it now believes a hike will not come until late 2015. For its part, the Fed has said nothing to nudge the market toward its amended (data-based) guidance; in fact, it is now suggesting that rates are likely to stay low “well past the time” the unemployment rate reaches 6.5%. Chairman Bernanke had in June of last year also indicated that QE3 monthly asset purchases could be expected to end when unemployment hit 7%, whereas a tapering of asset purchases is only now just starting with unemployment at 6.7%. All this suggests that the Fed’s experiment with data-based guidance is a flop. The 6.5% guidance may have been announced to help the public understand how the Fed would respond to “unanticipated changes in economic conditions,” but the Fed appears to have buried it because the unanticipated changes in the unemployment rate came about for unanticipated reasons – in particular, a big drop in the labor force participation rate. Before the Fed moves on to the next generation of guidance markers, it ought to think twice about the risks of worsening, rather than improving, the signal-to-noise ratio in its communications.  The jolt to the bond markets from the chairman’s unanticipated taper talk last May suggests what’s at stake as the Fed reverses the trajectory of policy from accommodation to tightening. New York Fed: Primary Dealer Surveys Federal Reserve: Minutes from the December 11–12, 2012 FOMC Meeting Financial Times: Four Problems That Question the Efficacy of Forward Guidance Hilsenrath: Jobs Report Alone Unlikely to Alter Fed’s Course   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”  

“Based on labor market data alone, the probability of a reduction in the pace of asset purchases has increased,” said Federal Reserve Bank of St. Louis President James Bullard on December 9.  Indeed, Fed watchers have been firmly focused on the improving labor market data in their handicapping of the prospects for an imminent Fed “taper” of its monthly asset purchases, known as “QE3,” which it began back in September 2012. Yet the Fed has a dual mandate, the second aspect of which, inflation, has been galloping away from the Fed’s target.  Indeed, the Federal Open Market Committee (FOMC) justified the launch of QE3 by referring specifically to the need to “ensure that inflation, over time, is at the rate most consistent with its dual mandate.” And “inflation,” Bullard noted, “continues to surprise to the downside.” As the FOMC begins two days of meetings, we benchmark the Fed’s performance against each element of its mandate as well as a combination of the two.  As today’s Geo-Graphic shows, the Fed’s preferred inflation measure has been moving away from the Fed’s 2% target faster than unemployment has been declining towards the 5.6% midpoint of the Fed’s range of longer-run estimates.  Since QE3 began, inflation has declined from 1.7% to 0.7% (at its last reading in October) as unemployment has fallen from 7.8% to 7%.  As our small inlaid graphic shows, if the Fed were placing equal emphasis on inflation and unemployment there would be no grounds for beginning to taper its monthly asset purchases at this time—the Fed is today farther away from its dual-mandate benchmark than it was when it launched QE3 last year. Wall Street Journal: Fed Faces Tough Decision on Bond-Buying Financial Times: Strong U.S. Jobs Data Raise Expectations of Fed Taper Economist: Is QE Deflationary?   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”