What’s the Fed’s speed limit? Today’s news will give clues

November 14, 2012

A Tuesday speech from a top Federal Reserve official and the minutes from the last policy meeting to be released Wednesday afternoon offer lots of clues about where the central bank is heading on  monetary policy. But to understand what is really going on at the Federal Reserve, it helps to start with a metaphor.

Dr. Bernanke is going for a Sunday drive, and his car is the U.S. economy. And back in 2008, that car came to a near halt (whether that was because of poor maintenance by Dr. Bernanke and his predecessors or forces beyond their control is an argument for a different day). Since 2009, he has been trying to get the car to accelerate back to highway cruising speed.


Federal Reserve Chairman Ben Bernanke is in the driver's seat of the U.S. economy. Manuel Balce Ceneta/Associated Press

He’s tried to push on the accelerator every way he knows how (such as the “QE2” program of bond buying in 2010, or “Operation Twist,” extending the duration of bonds in its portfolio in 2011 and 2012).

But whenever the car seems to be going a bit faster, Dr. Bernanke has taken his foot off the pedal, letting those programs expire. Because for Dr. Bernanke and his backseat drivers on the Federal Open Market Committee, breaking the speed limit (allowing inflation much above 2 percent) is intolerable. Plenty of people, in and outside the Fed, aren’t sure that Dr. Bernanke putting his foot on the gas pedal will do anything to accelerate the car at all. Instead, they want him to fix the engine (make more structural changes in how the U.S. economy works). And the longer he keeps his foot on the gas, the more likely Dr. Bernanke could go past cruising speed and end up exceeding the speed limit.

But in taking his foot off the gas so quickly, Dr. Bernanke allows the car to move too slowly — three years after the recession ended, the U.S. unemployment rate is still 7.9 percent.  And in September, Dr. Bernanke and the other passengers in the car who are on the Fed’s policy committee essentially said: “Enough. Let’s keep our foot on the pedal until we get up to cruising speed. We’ll try to pull our foot off the gas just as we’re hitting the speed limit, but we’re not going to panic if we go over just a little bit."

Here’s what that announcement looks like in central banker speak, from the Sept. 13 FOMC statement: “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.” 

We’re pushing the pedal to the metal, Bernanke and his passengers were saying, and we think we’ll need to keep it there for a while even after the car starts to accelerate.

But notice what was missing in that statement: any concrete announcement of what the speed limit was, and how much the Fed was willing to go over the limit to return to highway speed. If the Fed could offer the world specific numbers on those counts, it likely could help the economy get back on track; financial markets and business decision makers could plan for a future more confidently if, say, they understood exactly how fast and for how long the Fed was willing to push the car, which could make the results self-fulfilling. (Okay, here the metaphor breaks down.)

Charles Evans, the president of the Chicago Fed, has been arguing for more than a year for exactly that: a set of specific numbers for inflation and unemployment that would prompt the Fed to begin tightening its policies (or taking its foot off the accelerator). Evans originally argued for keeping easy money policies in place until either inflation hits 3 percent or unemployment drops to 7 percent. More recently, Minneapolis Fed president Narayana Kocherlakota came out with his preferred numbers, of 2.25 percent or 5.5 percent, respectively.

Within the Fed, this is known as a debate over “thresholds.” Officials there want it to be clear that they don’t view those numerical rates as “triggers,” which would necessarily prompt tighter money (though the term trigger makes a handy near-synonym for journalistic purposes). It’s also different from “targets,” which are the levels of unemployment and inflation that Fed officials think are appropriate for the long-run. (Those are 2 percent inflation and 5.2 to 6 percent unemployment, if you’re curious.)

We’ll stick with the Fed’s preferred terminology and call them thresholds, then — levels of inflation and unemployment that would prompt the Fed to begin at least considering tighter money. The concept is clearly gaining support on the committee; vice chairman Janet Yellen said in a speech Tuesday that she is “strongly supportive” of an approach like that advocated by Evans and Kocherlakota.

“I support this approach because it would enable the public to immediately adjust its expectations concerning the timing of liftoff [of interest rates] in response to new information affecting the economic outlook,” Yellen said at the Haas School of Business at the University of California-Berkeley. “This market response would serve as a kind of automatic stabilizer for the economy: Information suggesting a weaker outlook would automatically induce market participants to push out the anticipated date of tightening and vice verse.”

That is the clearest statement from a member of Bernanke’s inner circle of leaders that an approach along these lines is on the way, and the minutes of the Fed’s October policy meeting due out Wednesday afternoon will likely offer further color on how that discussion is proceeding behind closed doors.

But note that Yellen did not offer numbers of her own. As a leader of the policy committee, she may feel a need to be more circumspect than Evans and Kocherlakota, perhaps waiting until there is broad consensus before tossing out a number.

And the problem isn’t just confined to agreeing on numbers for the thresholds. There are others that Fed officials are trying to sort through: Should the numbers be based on backward-looking economic data, as opposed to the Fed’s forecast for the future? Wouldn't a short-term bump in oil prices or inflation triggered by other onetime factors make people think tighter monetary policy is imminent, even when Fed models see through those bumps? And on the unemployment side, what if the jobless rate declines, but for bad reasons — because people leave the labor force, giving up looking for work?

More broadly, the point of having a committee of 19 people gather in a room eight times a year to set monetary policy is to pull in all the information that can possibly be gathered about the U.S. and global economies to use to make decisions. Would reducing policy to two simple numbers defeat the point of weighing all the countless data points and pieces of evidence that are out there?

Those are likely the debates that were playing out in the committee room at the meeting three weeks ago, and which will be aired in Wednesday’s afternoon minutes and more speeches to come.

But this much is clear: Dr. Bernanke wants his car to go faster and has shown adeptness these last few years at convincing his many colleagues to help him step on the gas.

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Ezra Klein · November 14, 2012