State Dependent Federal Reserve Policy

Washington Post:  Huge News Out of the Federal Reserve

"Federal Reserve policymakers unveiled a huge surprise this afternoon. The central bank has now laid out specific numbers for the inflation and unemployment rates that will lead it to start thinking about raising interest rates."

It has long been understood that the Fed sets their policy instrument - the federal funds rate - to balance unemployment/ output and inflation.  If the economy slows and unemployment increases it is understood that the Fed will lower the fed funds rate to stimulate the economy.  If the economy speeds up and inflation picks up then it is understood that the Fed will raise the fed funds rate to slow the economy.  But the Fed has not always been explicit about when and under exactly what conditions they will move from one regime to the other.  Prior to 1994 the Federal Reserve did not even announce where they were setting their target for the fed funds rate.  That had to be inferred by where interest rates ended up after the Fed had taken action.

Starting in 1994 the Federal Reserve Open Market Committee (FOMC) began announcing targets for the fed funds rate.  In the post-meeting FOMC statement there was general discussion of the current state of the economy and a target level for the fed funds rate but it was still left to the public to divine from the level of the rate target what balance of inflation versus unemployment led to their decision.

Starting in the 1990s John Taylor and others began looking at the Fed's past decisions and modelling what rule the Fed appeared to be using to set interest rates ie what weights they were putting on inflation and unemployment in deciding where to set the fed funds rate....these became known generically as Taylor Rules.  Some even suggested that the Fed should announce a specific Taylor Rule that they would adhere to.  This would reduce uncertainty about their future actions.

Over the past few years the FOMC policy statements have contained both a target for the current fed funds rate as well as guidance as to how long they intended to persist that target rate.  The hope was that by reducing uncertainty about the Fed's future policy stance - firms and consumers would face less future interest rate risk - and hence be willing to increase long term term investments.  Here is an example from FOMC's  October 24, 2012  statement

"To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.  In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015."

With yesterday''s announcement the FOMC changed the form of guidance that they will provide to the public.  Now instead of announcing for how long they intend to persist the current fed funds rate they gave us explicit states of the world under which they would keep rates low.  From the FOMC's December 12, 2012 statement

"To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent."

What is the next step in the Fed's policy progression?  NGDP targeting maybe?