The Fed Leaves Policy Unchanged, Alters The Communication Of Policy

by: Tim Duy

We will be analyzing details of Federal Reserve Chairman Ben Bernanke's press conference for the rest of the week. For now, I am going to pass on my first take.

In my opinion, what struck me as most important was that Bernanke emphasized that the addition of thresholds was a change in the communication of the Fed's monetary policy, not a change in the policy itself. Indeed, I think the enhanced communication strategy is an important improvement. It increases transparency dramatically. As Bernanke noted, it is clearly more flexible in that the expectations for a change in Fed policy will fluctuate with the flow of data. In contrast, the Fed only changed the date when significant revisions in the economic forecast became evident. That said, as the statement makes clear, the Fed believes the threshold criteria are consistent with the previous date-based guidance. In this regard, policy is unchanged as the expected date of first rate hikes is unchanged.

Next, I think there will be a tendency to view the 50bp margin on inflation (the explicit statement that inflation might rise as high as 2.5% in the near term without an automatic review of the interest rate stance) as an indication the Fed is placing less weight on its inflation mandate. In contrast, Bernanke emphasized that the application of the dual mandate had not changed. If you believed the 2% inflation target was a hard ceiling, however, the margin of error looks like an easing of inflation concerns. If you think that there was room for symmetric errors around the 2% target (as I think the Fed has made clear recently), then the Fed's new thresholds are within an acceptable error band. Also, note the importance of long-run inflation expectations in the Fed's policy-making process. If the Fed believes that there is a real risk to long-run expectations, I would expect tightening regardless of the unemployment rate.

Also, I thought it important that policy seems to be headed in the direction illustrated by Vice Chair Janet Yellen:

Click to enlarge

Yellen
Along the optimal path, inflation approaches its long-run rate from above. The threshold guidance is perfectly consistent with this picture. The long-run inflation objective has not changed. All the Fed has done was make explicit what I thought Yellen already made fairly explicity - that marginal deviations from the long-run path would not automatically trigger a policy shift. Obviously, though, if economic conditions change, so too will the optimal path. That's the point of the thresholds - to communicate that no one path is set in stone. Policy will evolve according to economic outcomes.

Finally, Bernanke does not view the conversion of Operation Twist to outright purchases as a more expansionary policy. If you accept the position of St. Louis Federal Reserve President James Bullard, dollar-for-dollar, Operation Twist is a less effective stimulus. Thus, policy became easier. Bernanke, however, does not believe continued, outright long-term Treasury purchases of $25 billion/month is an easier policy. As such, the Fed arguably left policy completely unchanged Wednesday, altering only the communication of policy.