Minneapolis Federal Reserve Bank President Narayana Kocherlakota Friday criticized the central bank’s decision this week to drop numerical thresholds for unemployment and inflation from its policy statement, warning that this will create confusion about future Fed policy and “suppress” economic growth as a result.
“I dissented from the new guidance for two reasons,” he said. “The first reason is that the new guidance weakens the credibility of the Committee’s commitment to target 2% inflation. The second reason is that the new guidance fosters policy uncertainty and thereby suppresses economic activity.” His remarks were in a statement explaining why he cast a ‘No’ vote at Wednesday’s meeting of the Federal Open Market Committee.
Kocherlakota, however, supported the other aspects of the new forward guidance unveiled by the Fed, calling the intentions for the fed funds rate once the Fed is close to achieving its dual mandates “appropriate.”
In its policy statement Wednesday, the FOMC did away with its vow to keep interest rates close to zero so long as the unemployment rate is above 6.5% and inflation does not threaten to exceed 2.5%. Now, the committee says the progress made towards its maximum employment mandate and 2% inflation target will determine how long to maintain the current zero to 0.25% target range for the federal funds rate.
“The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2% longer-run goal, and provided that longer-term inflation expectations remain well anchored,” the statement added.
Noting the current low level of inflation, Kocherlakota said the FOMC’s new forward guidance “does not communicate purposeful steps being taken to facilitate a more rapid increase of inflation back to the 2% target.”
He added that the absence of such language weakens the credibility of the FOMC’s inflation target, as it suggests that the group “views persistently sub-2% inflation as an acceptable outcome.”
As for the FOMC’s quest for faster jobs growth, Kocherlakota argues that the new forward guidance does not do a good job of communicating the FOMC’s “desired rate of progress toward maximum employment.”
“Indeed, the guidance provides little quantitative information about what would characterize maximum employment. These omissions create uncertainty about the extent to which the Committee is willing to use monetary stimulus to foster faster growth, and this uncertainty is a drag on economic activity,” he said.
So what would he have preferred the FOMC to do instead? Keep the thresholds but lower the unemployment rate number, while making clear the health of the financial system will not be put at risk.
Since the FOMC added the thresholds to its statement in December 2012, the forward guidance has been “highly effective,” Kocherlakota said, so he would have tweaked the language in the following manner:
“The Committee anticipates keeping the fed funds rate in its current range at least until the unemployment rate has fallen below 5.5 percent, as long as the one-to-two-year-ahead outlook for PCE inflation remains below 2 1/4 percent, longer-term inflation expectations remain well-anchored, and possible risks to financial stability remain well-contained.”
He argued that this approach communicates the FOMC’s “willingness to use monetary policy tools to push inflation back up to 2%, while lowering uncertainty through greater clarity about the kinds of labor market and inflation conditions that are likely to be associated with a hike in interest rates.
“Finally, it deals with the unlikely possibility of risks to financial stability through an explicit escape clause,” he said.
Another change the FOMC made to its statement is that it said the current expectation among Fed officials is that “even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”
This is one change that “I strongly endorse,” Kocherlakota said.
“Those intentions are appropriate, and communicating them should help stimulate economic activity by reducing uncertainty about the likely path of the fed funds rate once the Committee’s goals are reached,” he added.