The Fed Moves the Goal Line

Following its meeting today, the Federal Reserve Open Market Committee announced no increase in the near-zero interest rate on Fed Funds and said it would reduce monthly bond purchases to $55 billion. In addition, it stated that it would be looking beyond the unemployment rate to additional indicators in order to assess the true state of the US labor market.

A recent Wall Street Journal article, “What Will It Take for the Fed to Raise Rates?” by Spencer Jakab, talks about how the Fed, now chaired by Janet Yellen, has changed its timeline for raising the Fed Funds rate no fewer than six times since the rate was set to near zero five years ago.

“First there was “some time” which became “an extended period.” Seeking more specifics, the market was then told rates would begin to rise in mid-2013, by late 2014 and then mid-2015. The latest threshold, an unemployment rate of 6.5%, barely below today’s level, will likely get the chop Wednesday following the Fed’s two-day meeting.”

Indeed, Jakab’s prognostication was correct. The Fed eliminated its criterion of a 6.5% unemployment rate, and it now expects that a move to increase the Fed Funds rate 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 statement also seemed to suggest that inflation and inflation expectations will play a larger role in determining the appropriate time to begin removing policy accommodation.

It is clear why the Fed decided to change its stated goal of 6.5% unemployment. The unemployment rate has not been a reliable indicator of the overall health of the labor market. This metric fails to consider several factors that suggest continued labor market weakness, such as 1) the staggering decline in the labor participation rate; 2) the very high number of long-term unemployed; 3) part-time jobs have been replacing full-time jobs; 4) the jobs being created tend to be lower-paying service jobs; and 5) a lack of meaningful growth in middle-class incomes. Given these continued problems, the Fed has decided it does not want to remain “painted into a corner.” The decision to begin raising the Fed Funds rate will now be determined by more qualitative factors that can’t be clearly defined. This change in policy offers the Fed more flexibility going forward.

But while we understand why the Fed did what it did today, we also think the Fed’s repeated policy revisions are a dangerous way to run a central bank. The most precious commodity the Fed has is its credibility. Businesses, consumers, investors, and the government need to be able to trust that the Fed will follow through on its commitments. If the Fed is unable to clearly define its goals and aspirations on the employment front, who is to say that the Fed will one day be able to ignore political pressure and take the steps necessary to “break the back of inflation” as Paul Volcker did in the 1980’s. After all, hasn’t the Fed been bowing to external pressures in, up until today, repeatedly heeding the calls to provide more clarity on its rate policy?

Philadelphia Federal Reserve President Charles Plosser wrote in a November, 2013 speech to the Cato Institute that, in his opinion, the adoption of “four limits on the central bank would limit discretion and improve outcomes and accountability:

First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective;

Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities;

Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach;

And fourth, limit the boundaries of its lender-of-last-resort credit extension.”

There is no doubt the Fed has a difficult job. Unlike some other central banks around the globe, the Federal Reserve is charged with both maximizing employment and maintaining price stability. Plosser’s first point above would remove the Fed’s employment mandate. We agree with Plosser. The Fed possesses no magic elixir to restore the labor market to the state it was in prior to the financial crisis. It should stop trying to do so.

I believe that the Fed has overreached in its monetary policy not just in response to the latest crisis, but pretty consistently over the 15-20 years. In an effort to lessen the effects of (inevitable) economic downturns, the Fed (and other central banks) has caused extreme financial distortions and dislocations. Despite repeated denials from Alan Greenspan, aggressive monetary easing was a very big factor in the inflation of last decade’s housing bubble. More recently, aggressive monetary easing has largely driven the stock market’s 170%+ move over the past five years. As Chairman Greenspan should have incorporated housing prices in his assessment of inflation, Bernanke, and now Yellen, should be incorporating financial asset prices into their assessments of inflation.

A strategy of inflating asset prices in the hopes of restoring a healthy labor market has not worked and probably will not work. More likely, the continuation of the Fed’s current path will sow the seeds of the next crisis. Plosser’s message of not promising what cannot be delivered is sound. Moreover, his subtext of the Fed not failing on its promises in order to maintain its most precious and vital asset of trust should be shouted from the hilltops. Today’s message from the Federal Reserve merely muddied an already opaque process.