Thresholds or Dates in Monetary Policy Communications
Since the onset of the financial crisis, the Federal Reserve has been using two main tools to carry out its monetary policy. First, there is quantitative easing, which is broadly defined as buying long-term securities to expand the balance sheet, and second, there is a promise to keep the federal funds rate low for an extended period. Both tools work better when the Fed clearly communicates potential changes to the public. In order for Fed policy to effectively stimulate the economy today, the public needs to have a good understanding of how the balance sheet will evolve over time (which is determined primarily by security purchases) and when the funds rate will rise.
Two different strategies have been employed to communicate the Fed’s intentions for both tools. The first ties future policy changes to certain endpoints. For example, the Federal Open Market Committee (FOMC) has announced that the federal funds rate will not likely be increased until a specified date (currently 2015). For quantitative easing, similar language has tied the end of purchases to the total size of the purchases. The alternative, which the Committee has been moving toward, is a data-driven threshold. This approach ties program changes to future conditions as they are reflected in various indicators, like unemployment rates or inflation.
This data-driven communication first appeared in the December 2012 FOMC statement, when the Committee indicated that the target range for the federal funds rate, at 0 to 1/4 percent, “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.”
With data-driven thresholds there is an automatic stabilizer component in the language. If the economy performs worse and unemployment is higher than expected, the guidance from the Committee will lead the public to expect that the date of the first increase in the federal funds rate will be pushed out and to expect that the volume of QE purchases will increase. Conversely, if the economy performs better than expected, the opposite occurs.
With date-driven language, if the economy performs worse than expected, no automatic adjustments occur. One can plausibly argue that the markets will expect changes in dates or another QE program, but there is not the same level of transparency as with data-driven language. Without this transparency, the effectiveness of these programs may be diminished.
For example, when the date for the first federal funds rate increase (“liftoff”) was first introduced in August 2011, it was mid-2013. (“The Committee currently anticipates that economic conditions…are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”) But economic conditions were not as strong as expected, so by the FOMC's September 2012 statement, the potential liftoff date had moved to mid-2015. (“…the Committee …anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.”)
With quantitative easing, a similar phenomenon has occurred. There have been three separate quantitative easing programs. The first two were specified in terms of a total volume of purchases that would be made, making them date-driven programs. The third program was announced with no total amount as an endpoint, just a volume of monthly purchases that would continue “until the outlook for the labor market has improved substantially in a context of price stability,” thereby employing partially data-driven language. Each additional program was added when the economy did not live up to the FOMC's expectations (much as the liftoff date was shifted outward when the economy was not fulfilling previous expectations).
The monetary stimulus from quantitative easing is roughly given by the Fed’s balance sheet and the expectation of the balance sheet going forward. When QE1 began in November 2008, the balance sheet was roughly $271 billion. Currently, the balance sheet is $3.4 trillion, and when QE3 ends, the Survey of Primary Dealers projects it to be $3.9 trillion. The Fed’s idea about the total stimulus needed for the economy shifted as new data became available.
Yet the current partially-data-driven threshold for QE3 has also led to some confusion. It was never clear what substantial improvement in labor markets meant. Which variables? How much improvement is substantial? (See “What Constitutes Substantial Employment Gains in Today’s Labor Market?”)
For example, at the beginning of QE3, the market—as reflected in the Survey of Primary Dealers—anticipated that the size of the program would be $1.1 trillion. But when surveyed prior to the January 2013 FOMC meeting, they had increased the anticipated size of the program to $1.2 trillion. Since April, the program has been projected to be bigger still, roughly $1.2 trillion to $1.4 trillion in size, and it is anticipated to end in the second quarter of 2014 rather than the first quarter of 2014.
However, over this period, the labor market has shown some signs of significant improvement. For example, in March the median Blue Chip forecast for the unemployment rate at the end of 2014 was 7.1 percent, and just prior to the June 2013 FOMC meeting it was 6.9 percent. The most recent Blue Chip survey shows an anticipated unemployment rate for the end of 2014 at 6.8 percent.
Survey of Primary Dealers: Evolution of Quantitative Easing Projections
|October 2012||December 2012||January 2013||March 2013||April 2013||June 2013||July 2013|
|Volume||$1.1 trillion||$1.1 trillion||$1.2 trillion||$1.2 trillion||$1.4 trillion||$1.3 trillion||$1.2 trillion|
|End date||End of 2014:Q1||End of 2014:Q1||End of 2014:Q1||End of 2014:Q1||End of 2014:Q2||End of 2014:Q2||End of 2014:Q2|
Notes: Projections are approximated from the median answers to questions on expectations for the monthly pace of purchases and questions on expected changes in the amount of domestic securities held in the System Open Market Account. All results are calculated from survey responses given prior to FOMC meetings.
Source: Federal Reserve Bank of New York.
2014 Unemployment Rate Forecast
|September 2012||October 2012||December 2012||January
|FOMC (central tendency midpoint)||7.0||7.1||6.9||6.7||6.6|
Sources: Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, Blue Chip newsletters.
The markets, desiring further guidance, took some from Federal Reserve Chairman Bernanke’s comments in the press conference after the June 2013 meeting. In that press conference, Bernanke stated that the market could anticipate that the Fed would slow the rate of purchases later this year, with an eye toward curtailing new purchases as the unemployment rate approached 7 percent and prospects for solid job gains remained promising. The market interpreted the comments as a sign that the Committee might be contemplating an unemployment threshold of 7 percent. But with the passage of time, the market may become increasingly likely to question the idea of a 7 percent threshold for ending QE3.
While clear thresholds are clearly desirable, they are also challenging. It is hard to quantify the exact economic conditions that the Fed will consider when deciding to increase the funds rate or taper QE purchases. By itself, any given indicator, such as measured unemployment, might not be a good measure of the economic conditions necessary for liftoff or tapering.