Wednesday, the FED dropped the unemployment rate as a benchmark for when to raise the federal funds rate. It has hinted at doing this for since January, since the indicator has been decreasing due to discouraged workers dropping out of the workforce as opposed to being hired. In its place, the FED has said it will use a more comprehensive approach, as it seeks to continue its accommodating monetary policy until inflation becomes a problem or employment picks up.
Not everyone shares this opinion, not even on the Board of Governors. The president of the Minneapolis Federal Reserve Bank, Narayana Kocherlakota, was the lone dissenter in this past weeks FOMC meeting. While he argues the new policy will lead to uncertainty, I question the viability of his alternative.
Central to his disagreement is the ambiguous nature of the FED’s guidance with respect to he interest rate going forward. Mr. Kocherlakota thinks that without a firm number to track, the FED’s commitment to its message won’t be taken seriously. However, the FED has had to move its previous number (6.5% unemployment rate) because it was about to be realized, and the FED would like to see the economy closer to full employment before rates increase. If the conviction of the FED rested on a deterministic number, then picking another on may seem as arbitrary as the first.
As an alternative, he suggests lowering the unemployment number to 5.5%, to provide a more determined target. I feel that there is a problem with this. Using data series from FRED, one of which is graphed below, it can be seen that the natural rate of unemployment in the short and long term is at or above 5.5% for the foreseeable future. Using it as a guide provides no valuable information since one would think that the FED would try to step off the zero lower bound if the United States was at the natural rate of employment. The FED needs a different metric in order to give it the leeway it needs.
If a policy with a firm benchmark is desired to insure credibility and confidence, instead of the unemployment rate why not use inflation as a guide? While some have argued to raise the target inflation, there are very rational reasons for why 2% was chosen, and nothing so extreme is needed. Instead, the FED should say that the central bank will do what it feels is prudent to foster a return to the natural level of output while inflation remains below the targeted levels.
I feel that Inflation will play a central role in the FED’s decision to raise interest rates, whether it wants to put a number to it or not. With inflation at its current levels, the FED has the price stability it needs. Provided this price stability remains, the FED should do all it can to stimulate employment. While a firm number would bestow confidence in markets, it can also cause exactly what we are seeing now when the economy reaches predetermined levels in unanticipated ways. Based on past results, the United States should have a little more confidence in its Central Bank to handle its business.