The FOMC: There is good commitment, and there is...

Yesterday's FOMC statement came with some unexpected news, but in retrospect I think we should have seen it coming. Here is the key change in policy:

The Committee 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 mid-2013.

Thus, the key change is applying a date to the "extended period" language that has been in the statement since late 2008. "Likely to warrant" is about as clear a commitment as I think will ever come from the FOMC. Compare this to what was in the November 2010 statement where QE2 was laid out:

...the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

That program was executed exactly as planned. There was some language in there to hedge against wild unforeseen circumstances, but once the FOMC gets this specific it has to stick to its guns or risk destroying its credibility.



A key problem here, of course, is that not everyone is on board, and the dissenting group - Fisher, Kocherlakota, Plosser - includes two of the most capable economists on the committee. Outside of Dudley, the New York Fed President, only one of the voting regional Fed Presidents, Evans (Chicago), voted in favor of the policy change. I think the dissenters are on the right side of this issue.



Given the current operating regime the Fed is in, with very large quantity of excess reserves in the financial system, and the interest rate on reserves (IROR) determining short-term nominal interest rates, the experience is not there, nor is there agreement on what theory to apply, for the Fed to understand well what it is doing. It is also very difficult for people trying to understand what the Fed understands, to know what is going on. In this context, how can the FOMC be so certain of itself as to commit two years in advance?



Further, it seems the outcome the Fed would hope for is one where inflation increases, the interest rate on reserves increases commensurately, and the Fed proceeds to sell off assets so as to normalize the state of its balance sheet, with zero exess reserves. Committing to IROR = 0.25 for two years risks two outcomes that seem equally bad (if we believe that 2% inflation is optimal). One is the too-high-inflation outcome: People anticipate high inflation, reserves start to look much less desirable, and the high inflation is self-fulfilling. The other is too-low-inflation: People anticipate low inflation, the reserves look more desirable, and low inflation is self-fulfilling. The first scenario is something that I have been worried about. The second scenario was a concern of Jim Bullard, and Narayana Kocherlakota. I think both are possibilities, i.e. there are multiple equilibria.



Fed officials like to talk about "anchoring expectations." In this circumstance, the kind of FOMC statement that would anchor expectations would be something like: "We anticipate raising the fed funds rate target (actually the IROR target, but what the heck) as observed and anticipated inflation warrants. Currently, we think we are on a path on which inflation will increase."