When might the Fed's unemployment and inflation thresholds be breached?

The Federal Reserve's Federal Open Market Committee has been providing guidance to help markets anticipate when the Fed will begin raising its federal funds rate target. The most recent guidance suggests that the target will not change at least until after an unemployment or inflation threshold is breached. Using a forecasting model, Federal Reserve Bank of Cleveland researchers Edward Knotek and Saeed Zaman estimate that the single most likely scenario is for the unemployment rate to cross its threshold by the third quarter of 2015, well before the inflation threshold is likely to be breached.

However, this "point forecast" captures only one possible way that unemployment and inflation may move over time. After accounting for the spectrum of potential outcomes, Knotek and Zaman show that there is greater than a 50 percent probability that at least one threshold will be breached two quarters earlier, in the first quarter of 2015.

The researchers also use their forecasting model to consider the impact of changes to the Fed's forward guidance, such as introducing an inflation floor--in essence, promising not to raise the funds rate target if inflation is below some value, even if unemployment crosses its threshold. They show that an inflation floor of 1.5 percent would delay by one quarter the most likely point at which both the floor would be satisfied and at least one threshold crossed.

The researchers say an inflation floor of 1.75 percent would create a much longer delay of four quarters. These results suggest that the choice of an inflation floor could exert a considerable delay on the liftoff of the federal funds rate from the zero lower bound.

Read When Might the Federal Funds Rate Lift Off?

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