Why Yesterday’s Fed Announcement Is a Big Deal

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Reporters raise their hands to ask Federal Reserve Chairman Ben Bernanke a question during a press conference following a Federal Open Market Committee meeting at the Federal Reserve Bank headquarters Dec. 12, 2012 in Washington, DC.

The Federal Reserve is a famously inscrutable institution. Given their ability to move markets, Fed officials have long been in the habit of speaking in careful, jargon-laced language that is often constructed with the express purpose of saying not much at all. That’s why when the Fed does communicate with the public, market watchers scrutinize each phrase and clause in order to divine any changes in the central bank’s behavior. And following yesterday’s final Federal Open Market Committee meeting of 2012, there was a single phrase that got the economics world buzzing, and sent financial markets into a bipolar tizzy.

(MORE: Is The Housing Recovery Just an Illusion Created by the Federal Reserve?)

Ready for it? Instead of promising to keep short-term interest rates at near-zero until at least 2015, as it did in its last statement, it pledged to keep short-term interest rates near zero at least until the unemployment rate falls below 6.5% or projected inflation gets above 2.5%. If this change doesn’t sound earth shattering to you, allow me to explain.

The Federal Reserve has two main tools for stimulating the economy. One is through “open market operations,” or the buying and selling of government securities to affect interest rates. The Fed didn’t change much in this regard. It’s continuing to keep short-term interest rates near zero and attempting to drive down long-term interest rates by purchasing longer-term Treasury securities and mortgage-backed securities at roughly the same pace as the past several months.

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The other powerful tool the Fed has is its ability to affect expectations of future interest rates. And this is the tool the Fed is leveraging with its recent policy change, and the one it’s been employing with greater intensity for more than a year now. It began in the summer of 2011 by promising that it would keep interest rates low until 2013. It doubled down on this strategy in January of this year by extending that date to 2014. Then, with the September 13th launch of third round of quantitative easing (aka QE3), the Fed promised that it would keep up a $40 billion monthly purchase of mortgage-backed securities “for a considerable time after the economic recovery strengthens.” And today’s announcement linked future policy to the unemployment rate, paired with a higher inflation target of 2.5%.

(MOREIs There a Reckoning Coming Thanks to Quantitative Easing?)

What’s the point of these various promises, and the difference between them? They’re all aimed at convincing businesses and consumers to get out and invest — now. Low interest rates now and in the future make sitting on cash very unattractive because money can’t earn much of a return sitting in a bank. If you’re convinced that low interest rates are definitely going to last for a while, you’re more likely to invest that money in some sort of enterprise — building a factory, say, or hiring more workers — then you would be if you thought interest rates would soon rise.

By stating how long it would keep interest rates low, as it did last year, the Fed was trying to create these expectations. But critics said the policy didn’t go far enough: Investors, they said, would worry that the central bank might back away from its low-rate stance at the first sign of recovery after that date.

So when it announced QE3, the Fed promised to keep up the bond buying until after the economic recovery gained steam. This was certainly a strengthening of the Fed’s dedication to low rates. But yesterday’s announcement that it would keep short term rates low at least until unemployment falls below 6.5% is the strongest commitment to working interest-rate expectations the Fed has shown yet. It further diminishes the possibility that the Fed will back out of its low-rate policy, even if inflation creeps up above its long-run goal of 2%.

This last point is particularly important to economists who favor aggressive Fed action. The reason is that the expectation of higher inflation by businesses encourages more economic activity now. Inflation erodes the value of present assets, which, again, makes it more attractive to employ those assets in productive enterprises right away.

With yesterday’s announcement, the Federal Reserve went all-in on expectations-based monetary policy. Some critics would like to have seen a higher inflation target or a lower unemployment rate target. But for all intents and purposes, we’re about to find out if this elegant theory can really hasten an economic recovery.

MORE: Why the Fiscal Cliff is the Wrong Thing to Worry About

8 comments
bryanfred1
bryanfred1

If government policy is to stimulate investment, now, then why the support for increasing the tax rate on capital gains?  When the rate was reduced 10 years ago it created substantially higher collections because each trade, asset sale, etc. became more profitable and the pace of activity increased.  Increasing the rate will have the opposite effect.  Not to mention that we want people to invest in an uncertain environment and in return are going to reward them less for that risk?  Good luck.

JonathanMartin
JonathanMartin

It was the final open market committee meeting of 2013? Are they going on a one year holiday?

carloseg
carloseg

Great.  So in the meantime we can look forward to higher food prices, higher energy prices, Obamacare taxes, and higher payroll and income taxes.  Face it folks, between Geitner, Bernacke,and Obama we may never see full employment for decades.

wrathbrow
wrathbrow

@carloseg  

There has never been full employment (as in zero percent). Part of the issue is there are jobs but not ones that people want to work. Fast food and related services jobs are always posting for work minded people. But some people would rather not work than work a job they don't like.

bryanfred1
bryanfred1

Full employment in the U.S. is around 4%.  At that point it's essentially frictional unemployment and the long-term unemployable.  We saw that both in the 90s and 2000s.

NamecNassianer
NamecNassianer

The high unemployment rate is due at least partially to offshoring of jobs.

There are many jobs being created at this time...in India, China, Taiwan, etc.

What can be done to make offshoring less attractive?

samtehman
samtehman

It is good that Bernanke finally put solid numbers to his plan to continue to keep interest rates low. I think there was a paper that said markets would react more positively and the benefits would be more long-term if they were able to target a specific threshhold for unemployment and inflation.

bryanfred1
bryanfred1

It's similar to the Permanent Income Theory of economics, that people and businesses don't change their habits based on short-term considerations (this has been the primary criticism of temporary stimulus packages).  Whether the Fed's low-rate policies actually spur investment activity in this economic environment can be debated, but giving the market specific signals can only be helpful.