What is the Fed Doing?

Last week, the statement following the Federal Open Market Committee meeting was accompanied by a summary of projections by the participants, which included for the first time projections on future interest rates.  The FOMC also released a statement clarifying its policy goals, and Bernanke held a press conference.

The statement on the policy objectives included the following:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

That appears to somewhat formalize what we've known for a while, that the Fed is shooting for 2 percent inflation.  Their interpretation of the employment part of their mandate was somewhat squishier:

The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. 

That sounds like a statement about the "natural rate" or NAIRU, which changes over time, and which economists can disagree about.  In this context, "maximum level of employment" isn't a very good phrase - it sounds like something Stalin would try to achieve in industrializing the Soviet Union - but "maximum" is the word in the Federal Reserve Act, so they probably wanted to stick with it.

The FOMC participants' projections of the federal funds target rate were summarized in this chart:

This indicates that most of them expect the federal funds rate to be above its current range of 0-0.25% in 2014, their projections that inflation in 2014 will be 1.6-2.0% and unemployment will be 6.7-7.6% notwithstanding.  Now that they've made their interpretation of their mandate more explicit, we can say the Fed is projecting inflation will be below their "mandate consistent" level and unemployment will be above it, but they will be raising rates anyway...

The language in their regular meeting statement was:

In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014. 

To be fair, though most of the participants are projecting a rate increase by 2014, all of the projected rates are still quite low relative to their "longer run" projection.

Many people seem to be interpreting the language about keeping rates "exceptionally low" through "late 2014" as an expansionary "open mouth operation" where the Fed tries to stimulate the economy by influencing expectations (and since the December statement said "mid-2013" they have opened the mouth wider).  If people believe short term rates will be lower for longer, long term rates will also fall.  Bernanke explained how this would work in his 2002 speech about deflation:

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. 

Credibility is indeed one major problem with such a strategy, as Gavyn Davies noted in a blog post previewing the FOMC release:

The problem for practitioners, however, is the time inconsistency of these proposals. It is one thing to promise now to hold interest rates at zero if inflation starts to rise in several years time, and quite another actually to do that in the circumstances of the time.

The temptation to renege on a long forgotten commitment, possibly made by an earlier Fed chairman under a previous administration, would surely be overwhelming once the economy is recovering. Since the private sector knows in advance that this would be the case, it would be extremely hard to persuade people today that such a policy would in fact be pursued in the future. And that would defeat its purpose.

However, while many knowledgeable observers are interpreting it that way (e.g., Stephen Williamson and Ryan Avent) it seems to me that the Fed is being careful to say that it is not promising to keep rates low, only that it believes the economy in 2014 will still be lousy enough that rates should still be low then. 

During the press conference, Bernanke seemed to place quite a bit of emphasis on the dual nature of the Fed's mandate, and even said "the Committee always treats its primary objectives on price stability and maximum employment symmetrically." Really?  In the past, I've thought he's seemed to give higher priority to inflation, so that sounded unexpectedly dovish to me.  One interpretation might be that he's listening to Chicago Fed President Charles Evans, who has argued the Fed needs to be more aggressive to try to reduce unemployment.  Scott Sumner also found dovish signs in the press conference.

An alternate interpretation is Bernanke felt the need to be extra careful to sound like he is being faithful to the dual mandate because the statement making the 2% inflation goal explicit sounds like another step towards "inflation targeting," which Bernanke advocated during his academic days.  Indeed, one of the reporters said: "Congrats on the inflation target or goal. That's a big achievement for you, I'm sure."

So, what is the Fed doing?  I'm really not sure, but I hope it works.