Recently, we argued that the Federal Reserve’s actions last month implied a new “reaction function” for the central bank. Fed officials always consider the state of the economy when making interest rate policy decisions. But they now appear to be putting different weights on their inflation and unemployment goals. In effect, the Fed has shifted the monetary policy goalposts.
For the last year, the Federal Open Market Committee has provided explicit guidance about how long it expects short-term interest rates to remain near zero. The guidance first said rates would remain low until “mid- 2013”, then “late 2014”, and now “mid- 2015”. The committee has also provided forecasts for inflation and unemployment over these periods. Thus, we can compare the forecasts to the official guidance about interest rates to get a sense of the level of unemployment the Fed would like to see before hiking.
We show these values in the exhibit below (we interpolated between annual values for the meetings in which the Fed signaled at mid-year rate hike). As of the November 2011 meeting when the Fed was saying rates would remain low until “mid-2013”, the committee’s forecast implied it would begin to raise rates when the unemployment rate reached 8.6%. In contrast, by the latest meeting, the forecasted unemployment rate at the time of the first rate hike was 6.7%— nearly two percentage points lower than the threshold used one year earlier. Quit a shift in the monetary policy goalposts!
Forecasted unemployment rate at time of first rate hike (%)
In our view, pushing down the targeted unemployment rate and pushing out the timing of the Fed’s first rate hike has been an important factor depressing the overall level of rates. As a result, any further shifts in the goalposts could have implications for markets more broadly. We think the current unemployment objective will remain unchanged for now. And indeed, San Francisco Fed President Williams said in remarks to Reuters this week that his own goal is for the unemployment rate to fall “somewhat below” 7%—roughly consistent with the 6.7% figure implied by the Feds latest forecasts. But we will have to continue to closely watch these comments given the changes over the last year.