WASHINGTON — Research from economists at the Federal Reserve Board of Governors argue for the central bank to keep the Fed Funds rate low even after the central bank passes its stated inflation and unemployment thresholds. But while the paper argues for reducing the unemployment threshold to 5.5%, it should not be assumed that a decision from the Fed's policymaking committee is imminent.
William English, director of the Monetary Affairs division at the Federal Reserve Board, along with fellow Fed economists J. David Lopez-Salido and Robert Tetlow, argue in a paper to be presented Friday at the IMF's annual research conference that there could be improved economic performance by lowering the stated 6.5% unemployment threshold at which the Federal Open Market Committee would start raising rates.
"Reducing the unemployment threshold improves measured economic performance until the unemployment threshold reaches 5.5%," they write. Further reduction, however, say to a 5% unemployment threshold, "reduces welfare, as the control of inflation becomes notably less precise," the research shows.
The FOMC, following its October meeting, reiterated the current unemployment threshold for keeping the Fed Funds rate very low. The committee "currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6.5%," its statement said.
Still, some committee members have argued for lowering the unemployment threshold, minutes from the meeting show. Minneapolis Federal Reserve Bank President Narayana Kocherlakota has consistently said the Fed should commit to delaying interest rate hikes until the unemployment rate falls below 5.5%.
But there's hardly consensus among committee members. San Francisco Fed President John Williams questioned the value of lowering that threshold and said it could even be counterproductive — despite telling MNI this week that the FOMC should not raise the federal funds rate from near zero for a long time, well after the unemployment rate goes below the FOMC's 6.5% threshold. Williams also said that in his view, the long-run unemployment rate is about 5.5%.
Boston Fed President Eric Rosengren estimated in a speech Monday that the Fed will have fulfilled its maximum employment mandate when the unemployment rate falls to 5.25%, an achievement that will require a more rapid pace of economic growth.
Bank of America-Merrill Lynch economists expect the Fed to change its forward guidance in due time "as it becomes clear that inflation is remaining persistently below target." Ethan Harris, co-head of global economics research, writes "we think they will note that pushing inflation back up to target requires a bigger drop in the unemployment rate. Hence, once they are really convinced low inflation is here to stay, they will lower their unemployment guidepost from 6.5% to 5.5 % or less."
English et al argue in their paper that the later departure in the federal funds rate that would occur with lower unemployment thresholds — i.e. waiting to raise the Fed Funds rate from zero at 5.5% unemployment, instead of at 6.5% unemployment — are associated with steeper subsequent climbs in the federal funds rate.
"Because current economic conditions are determined in large part by expectations of the entire future path of the real federal funds rate, these sharp climbs offset, to some degree, some of the stimulative effects of deferred firming," they write.
Unlike the impact of varying the unemployment rate threshold, the authors argue that "varying the inflation threshold has comparatively small implications — and indeed over some range, no material implications — for economic outcomes."
The research also made the economic case for keeping rates low even after passing the previously laid-out thresholds, which several Fed officials have reiterated in recent months as they try to separate the decision to pull back on large scale asset purchases and the decision to raise interest rates.
The paper suggests "it may be desirable to offset the effects of a period at the lower bound by maintaining the funds rate at a lower level than would normally be the case given economic conditions once the economy improves."
Waiting longer to raise rates also reduces the likelihood that Fed Funds rate would return to its lower bound, the research shows. "A strategy of remaining lower for longer provides precautionary stimulus when symmetric shocks confer asymmetric losses as they do at the effective lower bound," the researchers said.
The analysis also suggests that guidance about the anticipated path the Fed Funds rate once it is lifted from zero would also improve economic performance.
The Fed's policymaking committee will release new economic projection when it meets again Dec. 17-18, a meeting that will be followed by a press conference with Chairman Ben Bernanke. The Fed's efforts during and after the crisis to increase communications has moved them "considerably closer to inflation targeting," the paper said.
Still, because of the Fed's second mandate for maximum employment, the Fed "differs in important ways from a strict inflation targeting regime." One obviously, is it's stated target for unemployment rate, and second, "the Federal Reserve has considerable flexibility regarding the horizon over which it aims to return inflation to its longer-run goal."
The paper argues that while simple rules are successful when the Fed Funds rate is "far from its lower bound" in normal times, they "may be less reliable under conditions such as those that the U.S. economy is facing nowadays."
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