At the March FOMC meeting, Narayana Kocherlakota,the president of the Federal Reserve Bank of Minneapolis, dissented against the issued statement, objecting to the lack of numbers based guidance in regards to the taper. According to WSJ, Mr. Kocherlakota, “believed the change in the Fed’s language weakened its commitment to push very weak levels of inflation back to the official target of 2%”. Instead, he wanted to make 5.5% unemployment the new threshold for raising short-term interest rates. Keeping interest rates low until unemployment reaches 5.5% could take some time, and is certainly a more stimulate monetary policy than that of the current Fed regime. This so-called forward guidance would further drive down long term interest rates, and potentially stimulate the economy further.
While I may be slightly pessimistic about the recovery of the American economy, I’m not sure the Fed needs to have as loose of a monetary policy as Mr. Kocherlokota desires. Despite that disagreement, I believe it would be wise for the Fed to make it’s trigger for raising interest rates less nebulous than in the most recent statement. Even though I believe a 5.5% unemployment target might be too extreme, it certainly sends concrete and easy-to-interpret signals to the financial markets about the Fed’s future policy actions.
The vagueness of the Fed’s statement about keeping interest rates near zero “for a considerable time” after the taper ends seems especially strange in light of recent G-20 summits that were “essentially all about clearer communication”. I believe the Fed risks global instability when signals that could be interpreted in a variety of ways.
Others in the financial community have other worries about the policy of the Fed. A recent International Monetary Fund (the full report is here) report warns that if the U.S. grows faster than expected and begins raising interest rates too soon, the global economy would be weaken as a result of the increased borrowing costs for emerging nations. The IMF warns that a slowing growth in emerging markets might cause investors to pull money out of those countries and result in a global shockwave, perhaps a worse version of what we saw earlier this year. This is essentially a call for the Fed to be more cautious about the effect that their policy has on the world economy. As I wrote about in a previous post, I don’t believe that the Fed should worry too much about the global economy when setting their own policy. The Fed’s stated dual mandate is to help the U.S. economy achieve full employment and stable inflation levels, not to ensure global market stability.
The case of Mr. Kocherlakota and the opinion of the IMF provide both an internal and external criticism of the current Fed policy. Both seem to be indicating that the Fed should wait longer than expected to raise interest rates and return the economy to normalcy. As the graph to the right shows, employment has been steadily dropping over the past several years (although the unemployment situation is worse than the number implies), but inflation been much lower than the desired two percent target. These two facts combined seem to support Mr. Kocherlakota’s argument that the Fed enacting a more stimulative monetary policy would be more in line with the stated goals of the Fed. A more stimulative policy would keep interest rates near zero longer, coinciding with the IMF’s desire for lower rates.
However, there is certainly a downsize to the Fed making their policy more stimulative. A change in it’s course could destabilize markets and increase uncertainty. Perhaps the Fed doing a “good enough” job that everyone is currently positioned for would be better for the economy than the Fed strongly adjusting it’s expectations for a slightly expedited recovery. Frankly, determine the benefits from either policy is difficult, and personally I would prefer stability in such a situation.