It’s Fed speech week, but rather than spending much time supporting or criticising last week’s decision by the FOMC, Minneapolis Fed president Narayana Kocherlakota has instead drawn inspiration from Charles Evans and introduced his own conditionality-based “liftoff plan”:
As long as the FOMC satisfies its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent. …
Briefly, though, [by “satisfies its price stability mandate”] I mean that longer-term inflation expectations are stable and that the Committee’s medium-term outlook for the annual inflation rate is within a quarter of a percentage point of its target of 2 percent.
The substance of this liftoff plan is that, as long as longer-term inflation expectations remain stable, the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent. Note that neither of these thresholdsshould be viewed as triggers—that is, once the relevant cutoffs are crossed, the Committee retains the option of either keeping the fed funds rate extraordinarily low or raising the fed funds rate.
“Medium-term” is two years out, and you can see Kocherlakota’s justifications for choosing 2.25 per cent inflation and 5.5 per cent unemployment at the link.
This idea obviously is more hawkish than the Evans Rule, which calls for low rates at least until unemployment falls below 7 per cent or inflation rises above 3 per cent. On the other hand, using medium-term inflation expectations rather than inflation itself makes it easier for the Fed to ignore short-term “transitory” fluctuations that might show inflation rising above 2.25 per cent temporarily.
This has been interpreted as a kind of dove-ish shift by Kocherlakota and inconsistent with his previous views — specifically that structural factors are largely to blame for the sluggish employment recovery. Maybe, though really the idea he announced today doesn’t necessarily contradict his views on structural unemployment; instead it just elides the issue altogether. If unemployment is indeed mostly structural, then it is unlikely that the economy will get to 5.5 per cent unemployment before inflation climbs to 2.25 per cent.
UPDATE: From an interview with the FT after the speech…
“I’m putting less weight on the structural damage story,” said Mr Kocherlakota, arguing that recent research on unemployment pointed more towards “persistent demand shortfalls”. Either way, he said, “the inflation outlook is going to be pretty crucial in telling the difference between the two”.
There’s a logistical problem with the Kocherlakota Rule, which is that the FOMC doesn’t actually have a single 2-year forecast of unemployment, so a new innovation in the Fed’s communications policy would be necessary. The FOMC communications committee is already considering the idea of a consensus forecast, so that’s one candidate. (HT Robin.)
But this is somewhat irrelevant at the moment. The important point here is that there is another, perhaps unexpected supporter of conditionality-based easing, if one more sensitive to inflation than the dove wing of the FOMC. And this also seems like another sign that concentrating on the expectations channel (conditionality, inflation tolerance) alongside the portfolio balance channel (asset purchases) has made it easier for Bernanke to lock in support for his policies into the future.