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Reconfiguring the Fed’s Forward Guidance

Peter Ireland | 03/13/2014 |

The Federal Open Market Committee has an explicit, two percent U.S. inflation target. That announcement, made in January 2012, promises that the monetary policy mistakes of the 1970s will never be repeated, and offers reassurances that Federal Reserve policymakers fully deserve the American people’s trust and respect.

More recently, the FOMC has also referred consistently to unemployment in its policy statements, intended to offer “forward guidance” to the public about the future path of its federal funds rate target. These statements not only make clear that Federal Reserve policymakers are basing their decisions partly on the behavior of unemployment but, more worrisome, suggest that they are doing so with a specific, 6 1/2 percent target for the unemployment rate in mind.

Although these FOMC statements are carefully worded in ways that make it impossible to rule out that they remain consistent with a broader strategy of “flexible” inflation targeting, they nevertheless raise two sets of concerns. First, the disturbances that have hit the economy recently lack the distinguishing features of the “cost-push” shocks that give rise to a painful trade-off when trying to stabilize both unemployment and inflation. Shocks of that kind, though they do act to increase unemployment, also work to increase inflation. But the sluggish recovery experienced in the United States since the middle of 2009 has been accompanied by inflation rates that have remained, quite consistently, below the Fed’s two percent target. Any policy of inflation targeting—strict or flexible—would view bringing inflation back to two percent as quickly as possible as the first priority for Federal Reserve officials today. The additional reference to unemployment, especially to a numerical target for unemployment, seems wholly unnecessary.

Second, the recent behavior of the unemployment rate itself ought to be enough to remind anyone who has temporarily forgotten the painful lessons of the 1970s of why setting specific unemployment targets for monetary policy is not only redundant, but potentially harmful. Last Friday’s jobs report confirmed that over the period of slightly more than a year since the FOMC announced its 6 1/2 percent target, the U.S .unemployment rate has fallen from 7.9 to 6.7 percent. If people were to take the Fed at its word, and these data at face value, one would have to conclude that the FOMC’s goals for unemployment have been almost entirely achieved, and that the time to start raising the federal funds rate might soon be at hand.

Except that, as I have noted in a previous Economics21 article, the employment ratio—defined as the number of people who actually have jobs as a percentage of the total adult population—has hardly budged over the last year and has yet to recover any of the ground lost since the 2007-09 recession. Instead, the decline in the unemployment rate from its 2009 peak is due in its entirety to a decline in the labor force participation rate, a trend that began before, but accelerated noticeably during, the Great Recession and that is still quite far from being well-understood.

It is vital to sidestep this pitfall, which resembles all too closely the Fed's problems during the 1970s, when it also focused too much on unemployment. Many FOMC members are rightly concerned that it makes no sense to tighten monetary policy just because the labor force participation rate has fallen. Yet, if they live to up their words, that is exactly what they will be forced into doing. And if they back off, the disconnect between their words and their actions will stir up precisely the kind of public confusion that forward guidance was supposed to avoid.

The message from the latest data rings loud and clear: numerical targets for unemployment do not work. The Fed can and should care about unemployment. It can and should aim to fulfill its dual mandate. But theory and history, distant and more recent, all tell us that the best way for a central bank to stabilize unemployment is to stabilize prices first. It is time for the FOMC to jettison all references to specific rates of unemployment from its policy statements. Instead, the Fed needs to focus on bringing inflation back to target and keeping it there.


Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee, which will meet on Friday in New York City. This op-ed is based on a paper he will present at the meeting. 

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