Federal Reserve Board Vice Chair Janet Yellen suggested Tuesday the Fed may need to hold the federal funds rate near zero even longer than she and her fellow Fed policymakers have previously said.
And even after the Fed begins raising the overnight money market rate, it might need to keep it lower than either primary dealers expect or certain monetary policy rules prescribe, she said.
Yellen also emphasized that the Fed's announced 2% inflation target should not be viewed as a "ceiling" and that the Fed can "tolerate" temporarily higher inflation in pursuit of reduced unemployment.
The Fed's rate-setting Federal Open Market Committee has been saying since Sept. 13 that it expects to keep the funds rate near zero "at least through mid-2015."
But Yellen, in remarks prepared for delivery to the University of California, Berkeley, said a hypothetically "optimal policy" would keep the funds rate near zero "until early 2016."
She said this "optimal policy" would then keep the funds rate below the "baseline path," formulated from the primary dealers survey conducted prior to the September FOMC meeting, "through 2018."
Neither the primary dealers' baseline assumptions about the future path of the funds rate nor a commonly used "modified Taylor Rule" take proper account of the "balanced approach" the FOMC now takes toward meeting its inflation and maximum employment objectives, she said.
Yellen was referring back to a January statement of "longer-run goals and monetary policy strategy," in which the FOMC announced a 2% PCE inflation objective and estimated that the "longer-run normal rate of unemployment" is in the range of 5.2% to 6.0%.
In setting monetary policy, the FOMC said it "seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level."
When the two objectives are not complementary, the FOMC said "it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate."
Elaborating on that "balanced approach," Yellen said "if 2% inflation is the Committee's goal, 2% cannot be viewed as a ceiling for inflation because that would result in deviations that are more frequently below 2% than above and thus not properly balanced with the goal of maximum employment.
"Instead, to balance the chances that inflation will sometimes deviate a bit above and a bit below the goal, 2% must be treated as a central tendency around which inflation fluctuates," she said. "The same holds true for fluctuations of unemployment around its longer-run normal rate."
Yellen said "a policy that reduces unemployment may, at times, result in inflation that could temporarily rise above its target."
Indeed, she said, "the FOMC can tolerate transitory deviations of inflation from its objective in order to more forcefully stabilize employment without needing to worry that the public will mistake these actions as the pursuit of a higher or lower long-run inflation objective."
Using the FOMC's "balanced approach" as her point of departure, Yellen calculated an "optimal" path for the funds rate and contrasted it both to the primary dealer baseline and to the Modified Taylor Rule to come up with a longer time frame for keeping the funds rate very low.
"The optimal policy to implement this 'balanced approach' to minimizing deviations from the inflation and unemployment goals involves keeping the federal funds rate close to zero until early 2016, about two quarters longer than in the illustrative baseline, and keeping the federal funds rate below the baseline path through 2018," she said.
"This highly accommodative policy path generates a faster reduction in unemployment than in the baseline, while inflation slightly overshoots the Committee's 2% objective for several years," she added.
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