The Fed Ties Interest Rate Raise to the Tapering Instead of Unemployment Rate

Following today’s Fed’s meeting, the meeting statement has been scrutinized by every word to word. Of course, the biggest headline news was the Fed’s move to drop the unemployment rate of 6.5% as a threshold rate for raising interest rate from its meeting statement. Not only are Fed watchers reading the statement literally word to word, but also some of the policymakers at the Fed worried that some paragraphs of the statement might stir the market to a wrong way. To be more precise, Minnesota Fed President Narayana Kocherlakota was the only voting member who voted against the Fed’s decision to remove the key number of 6.5% from the statement. He says that the a paragraph in the statement may signal the Fed’s weakness when it comes to reaching the long-term inflation rate of 2%. The paragraph he was referring to is following:

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored [emphasis added].

It seems like the last sentence could have caused Mr. Kocherlakota to vote against the action because of it’s  possible inference of a lasting low inflationary period. As low inflation has continued since 2012, inflation expectation, also, hasn’t been reaching the goal of 2%. The expected inflation in 10 years is still lower than 2%. The following graph provided by the Cleveland Fed shows the market’s expectation of inflation in certain time horizons :
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Considering the low expected inflation in next few years, Mr. Kocherlakota’s worry of weakening the credibility of the Fed’s commitment to the 2% inflation is indeed valid. The Fed’s main goal thorough its forward guidance is to lower the expected interest rate for certain duration, but it’s another goal from which the FED is quite away from reaching it is to raise the inflation expectation, which in turn lowers the real interest  rate and boost investment.

Now let me interpret the Fed’s statement in my way. The WSJ posts an interesting post on how the latest Fed’s statement changed from last month’s. The following passage shows the change made in the statement from last month:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percentfor a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent, and provided that longer-term inflation expectations remain well anchored.

As we see from the change made in the statement, the Fed untied the possible date of raising interest rate from the unemployment rate and related it more to the Fed’s tapering process and its ending. Now, the Fed watchers should be giving more weights to the tapering process than before since it is now more related to the raise in interest rate.

This change could be progress forward for the Fed because as the tapering continues for at least throughout 2014, the market will have stronger signal of the Fed’s raising interest rate in near future. Even though then higher expected interest rate might seem worse for the economy, raised expected interest rate could actually induce more investment today, which is opposite to what one might assume. Because, the market will be surely knowing the coming of the raise in the interest rate in few months, firms should take advantage of the low interest rate today by borrowing and investing rather than postponing the investment project. This idea of surely known interest rate increase could create more investment is explained in my one of the previous posts.

 

7 thoughts on “The Fed Ties Interest Rate Raise to the Tapering Instead of Unemployment Rate

  1. lippmanb

    My post for yesterday was about the tapering as well. As far as unemployment is concerned, there is more than meets the eye. The main reason why the unemployment rate has been decreasing is that the labor force is shrinking.

  2. Chris Chegash

    As previously stated, unemployment hasn’t necessarily been giving an accurate representation of the market recently. I do think that the Fed will factor in the jobs market to the rate of the taper. I’d imagine if the jobs market took a sudden turn the worse the Fed would consider halting the taper. Thus, I don’t think that the interest rate is no longer tied to employment, but just in a less formal way.

  3. nickcoll

    I agree that the Unemployment rate is not the best thing to tie interest rates too since a drop in the unemployment rate could either be more people finding jobs, or less people in the labor force. Also, the fed most likely considers unemployment when thinking about a change in tapering so the interest rate is still affected by unemployment even if its not tied to it. Plus it makes common sense that interest rate’s would be closer tied to tapering since interest rates are going to raise the Fed stops purchasing more assets.

  4. haozhao

    Personally, the unemployment rate will not stop the Fed’s decision of increasing interest rate. First the unemployment is more and more useless to reflect real situation in the labor market. Second the unemployment rate is not the only factor to indicate whether the economy is in good shape or not.

  5. pranavrk

    It’s better that the Fed isn’t relying on unemployment data since drops in the unemployment rate just don’t have the same effect as they once did. Tying it to tapering does make it more flexible since the Fed can either accelerate or decelerate the tapering process based on other economic indicators like inflation, business confidence, consumer sentiment, etc.

  6. mdbold

    I like that your bring up the point of how we should interpret Fed releases. That’s very important for understanding policy and also important because the way people interpret it will affect that market.

  7. viczhou

    The fact that you made comparison between statements is very convincing. Overall, I think there will be fewer uncertainties facing the markets as the Fed tends to roll out reduction in bond purchases more clearly. Also, the less dependence on the unemployment rate for the tapering is reasonable because the index alone could be misleading due to factors such as the retirement of baby boom.

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