When US Fed Reserve unexpectedly decided to continue with asset purchase in September, analysts criticized the world’s top central bank for false-signalling and miscommunication. But, in the wake of Janet Yellen’s nomination to succeed Ben Bernanke as Fed Chief, it has become increasingly clear how much the ways at Fed have been evolved since the 2008 financial crisis.
Historically, monetary policy in US has been consistent with the Taylor’s Rule, which calls for increasing policy rate in times of high inflation and low unemployment, and decreasing rates when unemployment rate is high and inflation is low. Fed’s version of Taylor rule has involved forward guidance to the market in the form of calendar-based targets of policy rate, in order to achieve its medium and long-term inflation and unemployment rate targets.
The September announcement was significant not because it failed to meet market expectations, but because it marked a pronounced shift from Fed’s calendar-based guidance to linking of future monetary policy moves to hard economic thresholds.
This has now come to be known as the Evans rule (after Chicago Fed President Charlie Evans who first made the proposal). Under this rule, rather than promising to keep rates low until an arbitrary date, the Fed promises not to tighten monetary policy until the economy hits specific target for inflation and unemployment rates.
For those trying to figure out whether the Evans rule will hold sway under the Yellen chairpersonship come January, the term “optimal control” approach is important, as outlined in a series of speeches the upcoming Fed chief made last year.
For the uninitiated, it may sound like common sense that Federal Reserve should follow an “optimal” approach; but, under Yellen’s rule this will mean much more: that the policy rates will remain near zero for much longer than market expectations, even after the asset purchase programme ends.
Under this approach, the central bank would use a model to simulate the optimal path of short-term interest rates in order to hit the inflation rate of 2 percent and unemployment rate of 6 percent over long term. To quote Yellen, “as long as unemployment is further away from the target level than inflation, policymakers would keep low interest rates in an attempt to correct this, even if it means inflation runs slightly above target for a while”.
According to a Goldman Sachs report, “the central bank will choose a path for the federal funds rate which best meets its objectives over the next several years as a whole, even if this means committing to a policy rate that may appear sub-optimal at certain points along the way. For example, the chosen path may predict that in 2013, the Fed expects inflation in 2015 to be above its target but, nevertheless, commits to refraining from an aggressive monetary tightening at that point.”
According to Goldman analysts, using the optimal control approach means the rates will remain zero-bound until 2016, a year later than would’ve been suggested under the Taylor rule. Experts’ consensus suggests that Yellen’s work on optimal policy simulations resemble “nominal GDP level targeting” (NGDP), instead of the more familiar inflation-targeting approach.
It is interesting to note that NGDP-targeting approach was first advocated by Nobel Laureate James Tobin, Yellen’s mentor during her early years at Yale.
That policy rate will remain zero-bound under Janet Yellen; it is now almost a foregone conclusion. It offers an unconventional approach for generating economic activity in economies where governments no longer have fiscal space to intervene in the labour markets. Whether this approach would work for other economies is a question worth investigating.
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