Hoover Daily Report

The Fed Isn’t Working to Rule

via Wall Street Journal
Thursday, December 19, 2013

Federal Reserve officials have to be relieved at how well markets took their decision to start tapering. But the challenge of keeping markets calm is by no means over.

The Fed on Wednesday said that it would begin reducing its bond purchases next month, something that most economists didn't think it would announce until early next year. But the decision to scale back the bond-buying program came with a sweetener: The Fed said it anticipates keeping its target for overnight interest rates near zero "well past the time that the unemployment rate declines below 6.5%."

The Fed on Wednesday said that it would begin reducing its bond purchases next month, something that most economists didn't think it would announce until early next year. But the decision to scale back the bond-buying program came with a sweetener: The Fed said it anticipates keeping its target for overnight interest rates near zero "well past the time that the unemployment rate declines below 6.5%."

The Fed on Wednesday said that it would begin reducing its bond purchases next month, something that most economists didn't think it would announce until early next year. But the decision to scale back the bond-buying program came with a sweetener: The Fed said it anticipates keeping its target for overnight interest rates near zero "well past the time that the unemployment rate declines below 6.5%."

With Fed board members and regional bank presidents projecting unemployment won't fall beneath that level until sometime in 2015, Wednesday's language amounts to a strengthening of the Fed's signal that it plans to keep rates very low for a very long time.

It also amounts to a promise from the Fed that its policy on rates will ignore so-called Taylor rules.

Less a rule than a rule of thumb the Fed has tended to follow, Stanford University economist John Taylor's original framework says the target rate should be one plus 1.5 times the inflation rate plus half the output gap. The latter is the difference between where gross domestic product is and where it should be.

With a trio of influential Fed economists recently estimating the output gap at about 3%, and with the central bank's preferred measure of inflation running at about 1.2%, this suggests the target rate should now be 1.3%.

Many economists now accept more relaxed Taylor rules, which give more emphasis to the output gap and less to inflation, or which are based on the unemployment rate. These suggest the target rate now belongs at zero or lower.

But with the Fed projecting that the output gap will narrow, inflation will edge up, and unemployment will fall in the years ahead, even these more liberal Taylor rules suggest the Fed should be ratcheting up rates faster than it says it is going to do so.

Indeed, Fed officials' median projection is for the target rate to have risen to just 1.75% by the end of 2016. Typical Taylor rules would prescribe a rate of over 3%.

But if the economy continues to show signs of improvement in the months ahead, investors may start to question the Fed's continued commitment to keep breaking Taylor rules. Janet Yellen, expected to be confirmed by the Senate this week as the Fed's next chief, may have a tough time keeping them at ease.