Fed weighs change to rate guidance in quest for more flexibility

Federal Reserve officials are considering whether to alter their guidance on the likely path of interest rates to give them more flexibility to react to changes in the economy.

The Fed has said since March that its benchmark rate would stay low for a "considerable time" after it completes monthly bond buying intended to boost growth. With purchases set to end late this year and the Fed nearing its full-employment goal, that assurance will soon become obsolete.

The need for new guidance unites policy makers who want to keep rates low for longer, like Boston Fed President Eric Rosengren, with those who prefer to raise them sooner, such as Philadelphia's Charles Plosser. Both want to move away from promising to keep rates low for some unspecified period of time toward tying the first increase to changes in inflation and the job market. One stumbling block: how to change the language without sparking an unwanted jump in bond yields that could threaten to stifle the expansion.

"That's going to be hotly debated," said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York and a former Fed Board researcher. "If they can find a way to replace that with something that will mollify the market's reaction, you will see a change."

Tightening isn't imminent. In June, policy makers forecast that the benchmark federal funds rate would rise some time next year. They will issue new forecasts for the rate, along with economic growth, unemployment and inflation, at the conclusion of a Sept. 16-17 meeting of the Federal Open Market Committee.

Policy makers say they want to move away from any form of guidance based on time periods and dates, and instead stress that the outlook for the federal funds rate depends on progress toward the Fed's twin goals of full employment and low and stable inflation.

"As we approach levels of unemployment that many consider 'full employment,' the Fed should no longer issue guidance on the approximate timing of any monetary policy changes," Rosengren, who has backed unprecedented stimulus and doesn't have a vote on policy this year, said in a Sept. 5 speech in Boston.

Rosengren said the Fed should be "patient" in conducting policy "in the interest of ensuring that the economy reaches full employment and the 2 percent inflation target as quickly as possible."

Unemployment fell to 6.1 percent last month from 10 percent in October 2009. The decline has been faster than Fed officials expected at the end of last year, when they forecast that the jobless rate would fall to 6.3 percent to 6.6 percent by the end of 2014.

'Significant Progress'

Plosser dissented at the Fed's June meeting because the guidance didn't reflect "significant progress" toward the central bank's goals. Plosser, in a Sept. 6 speech in Florida, said that the "considerable time" language is "no longer appropriate or warranted."

Plosser said he sees no need to replace the phrase with any new language, because the Fed's statement already links policy with progress toward its goals.

"I'm not sure there needs to be anything to replace it," Plosser told reporters after his Sept. 6 speech. "My preference would be to just stop there."

Yet economists said Fed officials must tread carefully to avoid a repeat of last year's surge in borrowing costs that followed signals they might slow bond buying sooner than expected, an event some dubbed the "taper tantrum."

Changing Intentions

"Once you're saying something, the mere the fact you stop saying it is taken as a decision, as a definite indication that something has changed in your intentions," said Michael Woodford, a professor of economics at Columbia University in New York.

"I don't think anyone thinks if you just take it away no one will notice," said Woodford, who presented a paper at the central bank's annual symposium in Jackson Hole, Wyoming, in 2012 that emphasized the importance of forward guidance with interest rates almost at zero.

Fed officials, including Chair Janet Yellen, have fretted that low-rate assurances have lulled investors into a false sense of complacency, suppressing volatility in stock, bond and currency markets.

A disconnect between market expectations for interest rates and the Fed's own forecasts shows "the public might not give enough weight to how dependent the central bank's guidance is on both current and incoming data," researchers at the San Francisco Fed wrote in a report released this week.

U.S. stocks declined yesterday as the report fueled concern the Fed might tighten sooner than anticipated. The Standard & Poor's 500 Index lost 0.7 percent to 1,988.44 at the close of trading in New York.

Rate Forecasts

Fed officials in June forecast the federal funds rate will rise to 1.13 percent by the end of next year and to 2.5 percent a year later. Investors in federal funds rate futures foresee a slower increase, to 0.76 percent by the end of 2015 and 1.78 percent in December 2016.

The central bank's forward guidance evolved after it cut the federal funds rate almost to zero in December 2008, where it has remained. With no room to cut further, the Fed sought ways to assure markets borrowing costs would stay low to help the economy recover from the worst recession since the Great Depression.

They did that initially by saying that the funds rate, the interest banks charge each other for overnight loans, would stay "exceptionally low" for "some time," or for "an extended period." That was later changed to guidance based on a specific date.

In December 2012, the Fed dropped its calendar guidance, and instead said it would keep rates low as long as the jobless rate is above 6.5 percent and the outlook for inflation is no higher than 2.5 percent.

In March, the Fed dropped the link between policy and a specific level of unemployment, and adopted the "considerable time" language for the main rate.

To reassure investors, the Fed said also that dropping the unemployment threshold didn't indicate "any change in the committee's policy intentions as set forth in its recent statements."

Feroli said the Fed could adopt a similar assurance should it choose to move away from its "considerable time" pledge.

Even so, dropping the phrase "could get misconstrued" as signaling a policy change, he said. "This time around it will be a little trickier."