The Federal Open Market Committee should adopt a "thresholds" approach to monetary policy, whereby it would set levels for inflation and unemployment that would indicate a change in monetary policy rather than using a date to avoid sending "pessimistic signals," according to James Bullard, president and CEO of Federal Reserve Bank of St. Louis.
By setting "thresholds," or levels for inflation and unemployment, the FOMC wouldn't be predicting the economy will fare poorly through mid-2015, Bullard said, according to prepared slides of his presentation to the Little Rock Regional Chamber of Commerce.
"The Committee currently states that the policy rate will likely remain near zero until 'mid-2015,' this creates a 'pessimism problem' for the Committee. The date can be interpreted as a statement that the U.S. economy is likely to perform poorly until that time."
Bullard noted he's called the use of a date an "unwarranted pessimistic signal," which he believes is not the FOMC's intent.
When the economic outlook changes, the date when the first rate increase is expected should also change, Bullard noted, but the FOMC "has been reluctant to change the date unless the change in the outlook has been substantial. This means that markets at times have a somewhat different date in mind than in the Committee statement."
By using thresholds, when data are released, "private sector expectations concerning the timing of the first rate increase would automatically adjust," and there wouldn't be the pessimism, since "the stated threshold conditions could be met at any time."
While not defining what he thought the thresholds should be, he did mention that current definitions usually begin with 6.5% unemployment and 2.5% inflation.
The switch "does not necessarily mean that policy would be easier or tighter," he added, since those numbers are "consistent" with the expected rates when the first hike occurs, and inflation is generally expected to remain low.
But, he explained six "challenges" that would need to be addresses if the approach were changed: need to be sure this doesn't "represent a return to 1960s-style macroeconomics, in which many thought unemployment could be meaningfully targeted by the central bank"; must use either forecasts or the actual number for inflation and unemployment, not a mixed of actual for one and forecast for the other (Bullard like the actual values to be used); must not give the impression that unemployment and inflation are the lone variables of monetary policy; must stress that the unemployment rate is only one read of the labor market's health; unemployment can be high for reasons other than monetary policy; and the FOMC must understand that by using thresholds, they will be viewed as "triggers for action" by financial markets.
"Replacing the expiring twist program one-for-one with outright purchases of longer-dated Treasuries is likely more dovish than current policy," Bullard said.