Recently New York Fed President William Dudley expressed his desire for the central bank to rethink when it will consider allowing short-term interest rates to rise. The Fed had maintained that it would not allow short-term rates to rise until the unemployment rate fell to far below 6.5%. However, Dudley has argued that a more comprehensive approach was needed, that more factors than unemployment should be considered. “This is probably a reasonable time to revamp the statement to take out that 6.5% threshold because it’s not really providing any great value,” he claimed in early March[i].
In Wednesday’s policy statement, the Federal Open Market Committee confirmed Dudley’s sentiment, and announced that the 6.5% threshold would be scrapped.
The Fed’s monthly bond buying program has the ambition of stimulating the economy by keeping short-term interest rates near zero, which spurs lending. It was thought that the unemployment rate would be an accurate indicator of when sufficient stimulus had been achieved. However, as the Fed now concedes, the unemployment rate does not reflect all sub-optimal economic conditions. For example, the rate does not account for low wages, the underemployed, those working part-time, or those who would like to work but have left the work force entirely.
New Fed Chairwoman Janet Yellen on Wednesday announced that they would now be considering a broader range of economic factors, including long-term unemployment, those seeking full-time work who are only working part-time, inflation, and the number of people who are quitting their jobs. In announcing this, Yellen sought to stress to investors that interest rates will not be rising sooner than expected and that the eventual increases would be limited and gradual. “Economic conditions may, for some time, warrant keeping the target federal funds rate below levels the [Fed] views as normal in the longer run,” read the statement[ii].
However, investors sent the major indices spiraling downward after the release of the statement on concerns that the Fed was, in fact, expecting slightly higher rate increases than it was previously. The Fed’s median projection for short-term rates at the end of 2015 rose from 0.75% to 1%. The median projection for the end of 2016 rose from 1.75% to 2.25%.
This is a delicate topic and it is of the utmost importance that the Fed place the correct weights on the correct statistics when deciding when short-term rates should be allowed to rise. If the Fed allows rates to rise too early and too much, they risk undercutting the recovery they have worked so hard to support. If they wait too long, they put the economy at greater risk for future inflation than is necessary by expanding the money supply too much.
It is a great sign, early in Yellen’s time leading the Fed, that she is taking that seriously. The most important issue facing the Fed is how to end the stimulus program and when to do it. In pursuit of that end, the Federal Open Market Committee has a responsibility to use all the information at their disposal, not just the unemployment rate, to gauge the health of the recovery. The fact that Yellen was willing to make an announcement that would send the indices down should inspire confidence that the Fed is serious about finding the optimal money supply.
Da Costa, Pedro Nicolaci. “Fed Weighs How to Retool Rate Guidance.” The Wall Street Journal. 17 Mar 2014: A2. Print.
Hilsenrath, Jon. McGrane, Victoria. “Yellen Debut Rattles Markets.” The Wall Street Journal. 20 Mar 2014: A1-A2. Print.