Fed shifts approach in how it gauges U.S. economy

Ben Bernanke, chairman of the Federal Reserve

News Analysis

(MoneyWatch) The Federal Reserve's monetary policy committee announced today that it will continue its policy of maintaining exceptionally low interest rates and expand its "quantitative easing" program by purchasing bonds at the rate of $85 billion per month in a move to boost economic growth.

But the big news is the central bank's adoption of numerical thresholds that, if crossed, will trigger a reassessment of its existing policies. Specifically, the Fed said it will keep the federal funds rate within the 0 to 0.25 percent range "at least as long as the unemployment rate remains above 6.5 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."

This signals a change from time-based Fed policies that end on a certain date to those that are contingent on the state of the economy. The latter type of policy is considered more effective and less likely to cause credibility problems if, for example, the economy does worse than expected and the Fed is forced to extend the program beyond its pre-announced end.

But it's important to recognize that these are triggers, not thresholds. A 6.5 percent unemployment trigger, for example, means that if the unemployment rate falls below this level, a new policy is necessarily triggered, meaning the policy ends. But a 6.5 percent threshold brings about a discussion and a reassessment at the Fed of the appropriate policy -- but policy does not necessarily change. The Fed is instituting thresholds, not triggers, and its important to understand the difference.

There is one other change to note, and it also reflects the change from time-based to threshold-based policy. The Fed has been expanding the size of its balance sheet by approximately $85 billion per month, and it has also been selling short-term assets on its balance sheet and using the proceeds to purchase long-term assets in a program known as "Operation Twist." In effect, the central bank has been exchanging one for the other in an attempt to reduce long-term interest rates and stimulate long-term investment, housing and the purchase of durable goods such as cars and business equipment.

However, this time-based policy ends this month, and even if the Fed wanted to continue this program in its present form it couldn't do so because it is running out of short-term bonds to sell. In response, the Fed announced today that it "will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month," as it's been doing all along. After Operation Twist ends it will purchase longer-term Treasury securities, initially at a pace of $45 billion per month, bringing the total balance sheet expansion to $85 billion per month as before. Since the purchases are focused on long-term bonds, this continues the effort to reduce long-term interest rates.

The Fed believes that policy will be most effective if it can convince people policy will remain loose even after there are signs of a strong recovery.

However, one of the problems the Fed has had in its communications strategy is convincing people it will carry through with this commitment even if inflation drifts above the 2 percent target. In some sense, the Fed has too much credibility on inflation.

The adoption of numerical thresholds -- in particular an inflation threshold that is a half a percent above target and the commitment to maintain present policy "at least" until the thresholds have been met -- is an attempt to overcome this communication problem though a commitment to a clear, well-defined policy rule.