Today we are fortunate to have a guest contribution written by Jeffrey Frankel, Harpel Professor of Capital Formation and Growth at Harvard University, and former Member of the Council of Economic Advisers, 1997-99.
Friday’s jobs report showed the US unemployment rate falling to 6.6% in January. This is within a whisker of the 6 ½ % threshold that the Fed had announced at the end of 2012: It had said that it planned on keeping monetary policy easy at least until the unemployment rate had fallen below that level. But the central bank is nowhere near ready to raise interest rates, and so has had to back away from that particular “forward guidance.” The FOMC said on December 18 that it now expects to keep interest rates low well past the time that the 6 ½ % mark is reached.
Even though the Fed had always said that the unemployment threshold was a necessary but not sufficient condition for tightening, some critics believe that this shift in emphasis is a policy “U-turn” that has confused the financial markets. If so, it was avoidable.
The Bank of England has undergone a parallel sequence of events. In mid-2013 it gave similar forward guidance, with a threshold figure for UK unemployment of 7%. But Governor Mark Carney at Davos at the end of January signaled that he is now moving away from that guidance. The reason: the British labor market is now “in a different place” from what was expected: The Bank of England’s original forecast had been that the 7% number would not be reached until mid-2016; yet British unemployment, unexpectedly fell to 7.1% in the autumn and thus is poised imminently to cross its threshold as well. And yet, with the economy still weak and inflation still low, the monetary authorities appropriately do not want to raise interest rates anytime soon.
Janet Yellen is now at the helm of the Fed. She will have to re-think forward guidance and use information other than the unemployment rate. (And other than the inflation rate, which has been part of the guidance all along.)
The reason for the change in policy is again clear. The Fed hadn’t expected to reach the threshold for tightening in 2014 or even 2015. But unemployment has fallen unexpectedly quickly — not because of unexpectedly rapid growth in the economy which might call for earlier tightening (good news), but, in large part, because discouraged workers have left the labor force altogether (bad news). (To be sure, a big part of the four-year decline in the unemployment rate has indeed been due to a growing economy; and even part of the decline in the labor force participation rate is due to the benign long-term trend of baby-boom retirement. Nevertheless unexpected exit from the labor force is probably the biggest component of the unexpectedly rapid recent decline in the unemployment rate.)
Both the Fed and the Bank of England are accordingly now subject to much criticism for having delivered forward guidance that they were subsequently unable to stick to. Some of these attacks are unfair. No one should want the central bank to slavishly follow statements made in the past if circumstances have changed in an unexpected way. Any fair critic must acknowledge that the ubiquitous demand for transparency with respect to the central bank’s plans (phrased simply) inevitably conflicts with the reality that the future is unpredictable, in particular with respect to such developments as unexpected fluctuations in the labor force participation rate. This uncertainty is why the monetary authorities have always hedged their foreign guidance. Nobody is now violating a past promise. Are the critics then being entirely unfair?
Not entirely. There was another way. A year or two ago, many of us were suggesting that the monetary authorities could announce a target or threshold for Nominal GDP, instead of for inflation, real income, unemployment, or other alternatives. Some of us explicitly warned that a threshold phrased in terms of the unemployment rate would be vulnerable to extraneous fluctuations such as a decline in labor force participation, and argued that a nominal GDP threshold would be more robust with respect to such unforecastable developments.
Just over a year ago, for example, I wrote in favor of “a commitment to keep monetary policy easy so long as nominal GDP falls short of the target. It would thus serve a purpose similar to the Fed’s December 12, 2012, announcement that it would keep interest rates low so long as the unemployment rate remains above 6.5% – but it would not suffer the imperfections of the unemployment number (particularly its inverse relationship with the labor force participation rate…).” [Central Banks Can Phase in Nominal GDP Targets without Losing the Inflation Anchor blog, December 25th, 2012.] Other NGDP proponents issued similar warnings.
This is yet another instance of a long-standing point: if central banks are to focus attention on a single variable, the choice of Nominal GDP is more robust than the leading alternatives. A target or threshold is a far more useful way of communicating plans if one is unlikely to have to violate it or explain it away when things change later.
This post written by Jeffrey Frankel.