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Policymaking for the Future

It was one of the most highly anticipated events so far this year, and we are not talking about the royal wedding. Chairman Bernanke's press conference at the end of April drew notice from bloggers, news sources, and ordinary citizens concerned about the economy. Leading into the event, commentators reviewed the relevant economics lingo, explaining ideas such as “inflation expectations,” the “fed funds rate,” and “quantitative easing.” But after all of the build-up, reviews were anticlimactic: the conference was bland and boring. In spite of that appraisal, the Chairman's remarks did contain important information, and it is sparking a bit of debate in some circles.

What the prepared remarks made clear is that monetary policy is largely a forward-looking process. Chairman Bernanke reminded everyone that it needs to be since monetary policy works with a lag in its effects on both economic growth and price stability. This friendly reminder was surrounded by constant references to forward-looking economic indicators, which help policymakers determine where growth and price levels will likely be in the future.

Figure 1. Unemployment Rate

Speaking on the maximum-employment half of the Fed's dual mandate, Bernanke mentioned that policy was aimed at achieving growth so that the unemployment rate could return to its long-term normal level over time. Early on in his comments, he stated that the Federal Open Market Committee's (FOMC) longer-run projections for the unemployment rate could be interpreted as Committee participants' current estimates of the normal unemployment rate over the longer run. These projections, of course, are clearly conditional on appropriate monetary policy and current conditions. So, at this point in time, the goal of current monetary policy is to achieve economic growth to return the unemployment rate to a range of 5.2 percent to 5.6 percent. Clearly, the unemployment rate is lingering above that target. Signs that the rate is likely to fall in the near future are getting worse, as first-quarter real GDP growth came in below 2 percent, and expectations for the second quarter have been steadily declining over recent weeks. However, Chairman Bernanke made it clear that “the economy's longer-term rate of growth and unemployment are determined largely by nonmonetary factors.”

Figure 2. FOMC Projections: Unemployment Rate

On the other half of the Fed's dual mandate, the Committee participants' longer-run projections for inflation were also said to be a good indication of what the Committee judged to be most consistent with achieving price stability. Referred to as the “mandate-consistent” rate of inflation, Committee participants' projection for the longer-run inflation rate was a range of 1.7 percent to 2.0 percent. Again, their projections are dependent upon the current economic environment and the enactment of appropriate monetary policy. Chairman Bernanke explained that this longer-run inflation outlook, in contrast to economic growth and unemployment trends, is “determined almost entirely by monetary policy.” Some in the economics community have zeroed in on this statement, and a debate has arisen about what actually is the best predictor of future headline inflation.

Figure 3. FOMC Projections: PCE Inflation

One side of the debate generally believes that core inflation measures are a good predictor of intermediate-term headline inflation. Core inflation measures have remained moderate and below the “mandate-consistent” range, although they have ticked up slightly in the past few months. However, proponents on the other side of the debate advocate the use of a long-run trend in headline inflation to predict future headline inflation. This side has noted that core inflation measures have become less adept at determining longer-term inflation, especially over the past decade. Longer-run trends in headline inflation, say over the past 36 months, are providing the same information as core inflation, but that might not always be the case.

Figure 4. Inflation Measures

While the majority of economists and policymakers still side with the core-inflation conventions, a more vocal minority has emerged since the April Committee meeting and Chairman Bernanke's press conference. This dispute may be something to keep an eye on, because if views on inflation begin to shift, so too could future policy decisions.

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