The quickly falling US unemployment rate has caused the Federal Reserve to reevaluate how it communicates when it will raise interest rates.
Recently released minutes of the Federal Reserve’s last policy meeting showed that committee members disagree about the best way to communicate future policy as US unemployment has fallen close to their threshold for increasing interest rates.
The Fed had previously indicated that it would begin to discuss interest rate increases when the unemployment rate reached 6.5%. But with the economy still tepid and unemployment rapidly approaching that threshold, the Fed appears set to modify its forward guidance on rate policy.
According to the minutes, some members felt that the threshold number should be changed entirely while others suggested giving more details on which labor market indicators would be considered in making a decision. Another option for the Fed would be to state that rates would remain low if inflation continued to fall below the Fed’s 2% price target. However, there was general agreement that “it would soon be appropriate for the Committee to change its forward guidance.”
Yet, without a cohesive view on how to approach this change, the Fed risks muddying this guidance – which it believes is instrumental to conducting monetary policy in a low interest rate environment
Decreasing for the wrong reasons
Factors like decreasing labor force participation contributed the unemployment rate’s sharp drop sharply to 6.6% in January. This presents a serious challenge because it makes it more difficult to judge whether the improvement in unemployment actually reflects an improvement in the economy.
In order to help address this uncertainty and to avoid prematurely increasing interest rates, the Fed indicated in December that it would keep the current near zero target range for the federal funds rate “well past” the time unemployment drops below 6.5%. This now seems insufficient to fully guide market expectations, particularly if the unemployment rate continues to drop at its present rate (0.4% over the span of three months).
In recent testimony before the House of Representatives, Fed Chair Janet Yellen indicated that “the recovery in the labor market is far from complete.” She reinforced that she felt interest rates would remain low to help support the continuing recovery.
Yet, the minutes from January show that a “few participants” of the policy making committee think it might soon be appropriate to increase the federal funds rate. This surprised some market investors and the yields on Treasury bonds rose on the news. However, almost all the committee believe that the first interest rate rise will not occur until 2015.
A tough start
This earlier than expected discussion of rate increases, while not likely to actually shift policy, make Yellen’s job harder. She has to prevent the impression that the Fed will tighten policy early even as it reduces the pace of its accommodation (the “taper).
The disagreement indicated in the minutes over forward guidance coupled with the presence of a “few” inflation hawks could create uncertainty in the path of the policy. In June of 2013, the Fed’s stumbles in conveying the start date of the taper led to long term interest rate expectations spiking. The Fed wants to avoid this happening again.
It could look to the Bank of England for help. Facing a similar problem on unemployment, the BOE recently changed its forward guidance to focus on “spare capacity”, or the gap between the current state of the economy and its potential. It aims to eliminate that gap over the next two to three years.
The Fed might take this approach but the unemployment rate is a much simpler number to deal with and digest. However, it seems that the economic reality in the US might be too complex to base future policy on the path of just one number.