The New Fed Policy Thresholds: Nothing Sinister, But Hostage to Politics

The Fed Gets Even More Transparent

The decision by the Federal Open Market Committee (FOMC) to embrace policy target thresholds has taken monetary policy transparency to a new level. I recently alluded that the FOMC could embrace such a tactic in early-2013. The FOMC also decided to raise the ante on its asset purchase programme by extending the period over which it would continue to purchase longer-term Treasury securities. The size of the Fed’s balance sheet is likely to increase at a bare minimum of $85bn per month in 2013. The aim of extending the purchase programme for Treasuries is to maintain downward pressure on long-term interest rates, thereby providing an incentive to undertake capital spending and mortgage borrowing.

The conduct of US monetary policy has improved massively over the past 20-years. As recently as the mid-1990’s, the FOMC did not explicitly announce changes to its federal funds target. It was down to market analysts to determine from the pattern of open-market operations as to whether the Fed had altered its policy rate. The case for greater transparency is simple: many members of the FOMC believe that the efficacy of policy is enhanced through clarity in terms of the intended policy goals.

New Regime, Specific Policy Thresholds

The Fed had been publicly committed to keeping its exceptionally low federal funds target until mid-2015. The “problem” with this previous approach was that the duration of this period of abnormally low short-term interest rates had to be repeatedly extended. Fed policy formulation has been based on a so-called forecast-based approach under Chairman Bernanke. The internal forecasts of Fed staff initially set the tone for policy discussion. As time has progressed, the forecasts have become increasingly available for public/market consumption. The FOMC published its economic forecast 4 times during 2012, the most recent of which indicates that real GDP growth would not attain an above-trend reading until 2014.

The current FOMC central tendency forecast of long-term real GDP growth is 2.3-2.5%. This constitutes only a minor degradation to the 2.5% potential growth rate estimate during the previous cycle. Chairman Bernanke recently expressed his personal concern that potential growth could, in fact, be significantly lower than the FOMC’s central tendency forecast. This would imply that elimination of the economic slack created by the Great Recession could take far longer than previously estimated. Under these circumstances, the FOMC may have felt uncomfortable being forced to announce a further extension of the duration for abnormally low short-term interest rates. The decision to announce thresholds essentially conveys to financial markets what constitutes a return to normality in the eyes of the FOMC.

The Policy Thresholds; Nothing Sinister

Faced with the problems of achieving its dual mandate, the FOMC announced, back in January, a 2% long-term target for the core personal consumption expenditure (pce) deflator measure of inflation. The timing of the announcement was slightly unfortunate, because the core pce deflator started the year at +1.9%, just under the 2% long-term target. At the time, the ability of the Fed to ease was seemingly limited due to this dynamic. The core pce deflator constraint has receded during 2012. The current 12-month change is just +1.6%, implying that deflationary threats have not yet been fully-eliminated.

During 2012, the FOMC decided to promote maximum employment as being the more important policy goal.  The policy threshold for the unemployment rate is 6.5% versus the current level of 7.7%. There is nothing sinister about the 6.5% threshold level: it is at the upper-end of the estimated 6-6.5% range for the so-called natural rate of unemployment. The policy threshold for unemployment will only remain valid as long the core pce deflator is not 50 basis points or more above the 2% long-term target. The FOMC has, therefore, decided to re-embrace a more balanced approach to its dual mandates. The level of inflationary expectations over the next 5 and 10 years are approximately +2.1% and +2.5%, respectively. The Fed’s maximum tolerance of the core pce deflator above the 2% long-term target has been very much dictated by the current structure of inflationary expectations in financial markets. While the FOMC is keen to reduce unemployment, it is also wary of unhinging hitherto well-anchored inflationary expectations.

Labour Market Dynamics: Crucial for Fed Policy

The announcement of the 6.5% threshold for the unemployment rate needs to be placed into context: the FOMC’s central tendency forecast suggests the threshold will not be reached until 2015. Is there a danger that the unemployment rate could hit 6.5% before 2015? The relationship between the unemployment rate and economic growth is often quoted within the context of Okun’s Law: the deviation of the unemployment rate from its natural rate will determine by how far the economy is growing above or below trend. The stability of the relationship between unemployment and the rate of economic growth will vary through time. The long-term crude rule of thumb has been for a 1% increase/fall in the unemployment rate to be associated with a -2% decline/rise in output relative to its potential long-term trend. Thus, assuming that the 6.5% threshold for unemployment equates with the FOMC’s estimate for the natural rate, then the current 7.7% level of unemployment is indicative of current GDP being 2.4% below its potential level.

The civilian unemployment rate has exhibited varying degrees of stickiness during the post-Great Recession recovery. The average rate during 2011 Q4 was 8.7%. It has averaged 7.8% during 2012 Q4. This decline in the unemployment rate compares with average GDP growth during 2012 of “just” +2.0%. The decline in the unemployment rate is seemingly large against a backdrop of +2% quarterly real GDP growth. It implies that potential GDP growth may, in fact, be somewhat lower than the 2.3-2.5% embedded within the FOMC’s central tendency forecast. Should the economy break the 2% growth trap and enjoy faster economic growth, then the civilian unemployment rate could fall more quickly to the 6.5% threshold than expected. What would be the implications for monetary policy?

Fed Policy Implications under Slower Potential GDP Growth

A declining civilian unemployment rate in the wake of just 2% headline GDP growth potentially contains some sinister developments with respect to the supply-side of the economy. It may indicate that underlying productivity in the US has suffered a setback. In other words, in order to achieve any given level of output, the amount of labour input required has increased, thereby reducing the unemployment rate. If this has, indeed, happened, then the 6.5% threshold level of unemployment could be reached sooner-than-expected, forcing the Fed into a more “normal” policy stance.

Strong productivity growth has underpinned the early stages of the post-Great Recession recovery: it explains the hitherto sluggish decline in the civilian unemployment rate and impressive recovery in corporate profits in a low inflation environment. Fading productivity growth should result in higher required labour input and a squeeze on corporate profitability, assuming a continuation of weak corporate pricing power.

The most recent output estimates for non-financial corporations during Q2 and Q3 indicate falling productivity, rising unit labour costs and upward pressure on selling prices. In order words, there is evidence to suggest that corporations are attempting to partially recoup the erosion to profit margins via higher selling prices. This is a healthy development: it signifies the operation of the normal dynamics that underpin the corporate profits cycle. The lingering risk of the full-blown fiscal cliff scenario means that the developments of Q2 and Q3 could be reversed very quickly in 2013 H1. A recession induced by tightening fiscal policy would raise the unemployment rate and crush any semblance of corporate power very quickly. For the moment, the Fed appears genuinely concerned that this outcome could, in fact, unfold.

Reaching the Policy Thresholds: Political Events Could Be Crucial

Given the 2% growth trap that the US is currently ensnared within, the overwhelming risks to the economic outlook are biased towards the downside, given the backdrop of a looming fiscal cliff. If the full-blown fiscal cliff unfolds and the unemployment rate starts rising back above 9%, then the 6.5% policy threshold will disappear into the distance, along with any risk of the core pce deflator hitting +2.5%. In fact, there would be a strong potential for a return to deflationary psychology. Further easing from the Fed would be an inevitable outcome.

In short, US monetary policy conduct in 2013 is very much hostage to political events. Small wonder why the Fed has been appealing to Congress to resolve the fiscal cliff sooner-rather-than-later. Ideally, the Fed would like to see a long-term resolution reached. Kicking the issues down the road for a couple years would not be taken well by financial markets, and the Fed would potentially be facing the identical predicament it faces today in trying to cushion the impact of tightening fiscal policy.

Summary and Conclusions

The Fed has decided to invoke policy target thresholds for the unemployment rate and inflation, along with another tranche of purchases of long-term Treasury securities. The objectives are to exert further downward pressure on long-term interest rates and to spur economic activity via greater policy transparency.

There is nothing sinister behind the policy thresholds. The Fed believes that they are consistent with its dual mandate. This represents a reversion to a more balanced approach, after briefly giving maximum employment policy priority.

Reaching the 6.5% threshold for the unemployment rate will depend on potential shifts in the operation of so-called Okun’s Law. Unemployment has fallen with GDP still below its potential level, possibly indicating deterioration in labour productivity. This will put downward pressure on corporate margins.

The fiscal cliff remains the biggest threat to the policy thresholds being reached. A recession induced by fiscal tightening would raise the unemployment rate in 2013 H1 and re-introduce deflationary pressures into the economy. Under this scenario, the Fed would, without hesitation, attempt to cushion the impact of fiscal tightening.

About Said Desaque

I'm a professional economist in financial services, with a keen interest in international relations, along with their implications for economic development.

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