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.