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December 17, 2012
In the US, there has been a clear shift in the Fed's policy reaction function, or "Taylor Rule", increasing the weight placed on unemployment and reducing the weight on inflation. The nature and importance of the Fed's policy shift has not yet been fully understood, because it was not really spelled out by Chairman Bernanke in his press conference this week.
I'd score that comment about half accurate. Here's what the Chairman actually said in that press conference:
Mr. Chairman, what prompted the Committee to make the decision at this particular time to specify targets? And by taking an unemployment rate that is quite low compared to currently, does that shift the balance of priorities in terms of your dual mandate…more in the direction of reducing unemployment rather than inflationary pressures?
…It is not a change in our relative balance, weights towards inflation and unemployment, by no means. First of all, with respect to inflation, we remain completely committed to our 2 percent longer- run objective. Moreover, we expect our forecast, as you can see from the summary of economic projections, our forecasts are that inflation will actually remain—despite this threshold of 2.5 [percent]—that inflation will actually remain at or below 2 percent going forward…
I think both sides of the mandate are well-served here. There's no real change in policy. What it is instead is an attempt to clarify the relationship between policy and economic conditions.
That's about as clear a statement about the constancy of the Federal Open Market Committee's (FOMC) objectives as I can imagine. The reason I am giving Davies half credit is his reference to the Taylor rule, and his article's theme that what has changed is the FOMC's "reaction function"—a fancy name for how the Fed will respond to changes in economic conditions in pursuit of its objectives.
I think the intent of recent changes in language is pretty clear, evidenced by comparing this statement following the August FOMC meeting…
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.
… with this one, introduced after the September FOMC meeting:
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
I added the emphasis above, as in my view it is the key change from previous statements. At least from the point of view of the Atlanta Fed's research staff, there wasn't much of a shift in the economic forecast between August and September (or September and December, for that matter). The change in date from late 2014 to mid-2015 is (I argue) best understood, not in terms of changing economic conditions, but in terms of this explanation, from Mike Woodford's paper presented at the Federal Reserve Bank of Kansas City's 2012 Economic Symposium:
We argue for the desirability of a commitment to conduct policy in a different way than a discretionary central banker would wish to, ex post, and show that (in our New Keynesian model) the optimal commitment involves keeping the policy rate at zero for some time after the point at which a forward-looking inflation-targeting bank (or a bank following a forward-looking "Taylor Rule") would begin to raise interest rates.
This, of course, is exactly the change in reaction function to which Davies refers. But two points need to be emphasized. First, the deviation from the Taylor rule that Woodford describes is an exceptional measure designed to deal with circumstances in which policy rates have fallen to zero and can fall no more. Deploying such measures in the current extraordinary circumstances need not reflect some fundamental change in the approach to policy when things return to conditions that more closely approximate normal.
Second, and more importantly, the Chairman's comments make it abundantly clear that whatever changes may have occurred in how monetary policy is implemented, there is in no way a change in the weight the Committee puts on its price stability mandate. On that there should be no confusion.
By Dave Altig, executive vice president and research director at the Atlanta Fed
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