Commitment in action: Federal Reserve’s interest-rate “path”

It is a big shame that today’s FOMC meeting is one of those not to be followed by a press conference and a Q&A with Ben Bernanke. The policy decision is one of the more spectacular in recent times. Not because the Fed decided to keep the target for the Federal Funds Rate within the 0–0.25% range, where it has been since December 2008. The big news, however, is that the non-move is accompanied by an explicit commitment to keep it there for the next two years (if current conditions continue). This is very specific compared to previous talk about keeping rates low for “an extended period” (which has been the credo since 2009, and which in April this year was mentioned to be just “a couple meetings”).  Hence, there would have been lots to ask Bernanke about. Also, the fact that three of the ten FOMC members voted against the decision is quite unusual. The opponents—all non Federal Reserve Board members—were Richard W. Fisher (Dallas Fed), Narayana Kocherlakota (Minneapolis Fed), and Charles I. Plosser (Chicago Fed). All preferred that the “extended period”–phrasing had been maintained.

The decision to shift policy so drastically is based on new downward revisions of US GDP-growth, a poor labor market performance, and weak spending activity. The associated firm and explicit commitment to a zero-interest rate policy for (at least) two years is well grounded in modern macroeconomic theory, where the ability to affect expectations is viewed as crucial for successful monetary policy. Keeping rates credibly low for a long time can not only help lowering longer rates, but also help increase inflation expectations (although this is something not to be mentioned in the US these times), such that the real interest rate goes down. Apparently, the wording “an extended period” was just not seen as good enough.

I think it is a bold move to be so specific, and it is interesting to see how it plays out. In the press release accompanying the announcement, it is mentioned that other “policy tools” are discussed on an ongoing basis, but nothing specific is mentioned. Probably this reflects that the number of actual tools is beginning to shrink drastically. This leaves the Fed with just words to affect the economy. Today’s statements are testament to that.

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5 Responses to Commitment in action: Federal Reserve’s interest-rate “path”

  1. jmg says:

    I am really a little bit perplexed. The crucial sentence in the FOMC statement is:
    “The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” At one of the next meetings between today and mid-2013 the economic conditions can unexpectedly improve, so that the FOMC can increase the interest rate without contradicting the above sentence. The three dissenters “would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period.” Where is the great difference?

    • As I see it, the mentioning of an explicit date is a much stronger commitment than just saying “an extended period”. Ex post, actual events can of course turn out to be consistent with both statements, but ex ante there is much more commitment in presenting an actual date. And thereby, in my view, a stronger potential for moving expectations.

  2. jmg says:

    Paul Krugman:
    “The Fed didn’t announce a new policy. And despite what some press reports said, it didn’t even commit to keeping rates low; all it did was say that if the economy stays weak, rates will stay low — well, duh — and that it might think about doing other stuff one of these days”
    LINK: http://krugman.blogs.nytimes.com/2011/08/09/the-fed-states-the-obvious/

    I think Krugman is absolutely right on this and I am now perplexed by the reaction of the financial markets: equity prices up, but the fed saying the economy will be growing only slowly. Bond Yields down, but the Fed made no unconditional commitment to holding down the Fed funds rate for the next 2 years. There seems to be some wishfull thinking. It will be interesting to see, when they will wake up.

    • Well, Krugman is Krugman. I don’t know what he had expected. A particular date is in my optic very different from a vague statement as “extended period”. Note also that Bernanke had recently said that this “extended period” was about to run out. So I think it was an important move. Nevertheless, the market reaction may indeed seem odd. But I wouldn’t put too much in daily movements. Lots of the increases could just be corrections from the great falls the day before.

  3. Niels Blomquist says:

    Indeed a very interesting move! I was a bit surprised though. The shorter term interest rates (maturity of 2-3 years) didn’t seem that high to me – i.e. no market expectations of interest rate hikes in the comming years. But in order not to water down the “extended period” language it might be useful to be more specific on the expectations of the FOMC. It will be interesting to see whether they will continue doing this in “normal times” like Riksbanken and Norges Bank or just leave it to exceptional times like Bank of Canada. However, nice to see that the FOMC following recent academic litterature..

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