Changing Economic Relationships: Implications for Monetary Policy and Simple Monetary Policy Rules
In a speech on Thursday, Boston Fed President Eric Rosengren noted that the Federal Reserve's policy committee in March provided two conditions for raising short-term interest rates. First, the policy statement indicated that the Federal Open Market Committee needs to see further improvement in the labor market. Second, the Committee needs to be reasonably confident that inflation will move back to its 2 percent objective over the medium term.
"At this time," said Rosengren, "I do not think that either condition has been met. Although there has been noticeable improvement in the labor market over the past few years, "since March the indicators have been a bit mixed. Furthermore, inflation remains stubbornly below our target of 2 percent."
When the Fed publishes Committee members' forecasts, many observers focus on the interest rate projections. But Rosengren urged a focus on "the recent striking reduction in the longer-run estimates of the unemployment rate and the reduction in the level of the federal funds rate that FOMC participants expect to see in the longer run," as well.
"In addition to being relevant for current monetary policy decision-making, these measures are also relevant to the discussion of how best to utilize simple monetary policy rules" - a topic of much debate among economists as well as lawmakers.
These key variables can change - and, according to FOMC participants' published projections, have changed significantly over the past three years. The variability of these two key estimates - normally assumed to be constant in simple monetary rules - "highlights just one of the many perils of using simple rules to constrain monetary policymaking," said Rosengren.
A number of factors may be behind the lower estimates for the unemployment rate in both the medium and the longer run. One possibility is that the standard unemployment rate usually quoted may not fully capture the current slack in the labor market. Another reason may be "the absence of wage and price pressure," which "is consistent with some slack still remaining in the labor markets, even with an unemployment rate that has fallen to 5.5 percent," said Rosengren.
Rosengren also discussed the implications of lower longer-run, or equilibrium, federal funds rates. First, rates may not need to rise as much to return to "normalized" interest rates. "This is one reason that rate increases might not need to follow as steep a path as in previous recoveries." Second, policymakers may have less room to lower interest rates in the event of economic weakness, "and will thus be more likely to hit the zero lower bound for interest rates." He added that "this may imply that inflation targets have been set too low."
These changes provide a further rationale for looking beyond simple monetary rules, which "cannot capture the full complexity involved in determining appropriate monetary policy, especially during periods when economic relationships may be changing." Many of these simple rules would have dictated a tighter policy for some time, even as employment has fallen short of full employment and inflation has run below the Fed's 2 percent goal, more than seven years since the start of the recession.
"For me, there is wisdom in utilizing a more flexible and comprehensive set of variables and models when considering appropriate monetary policy," said Rosengren. "Rules are likely best used as guidelines, along with a host of other inputs - the most important of which are good judgment and hard-won experience."
Rosengren was speaking at Chatham House in London.