(Bloomberg Opinion) -- When the U.S. Federal Reserve holds its next big policy-making meeting, officials will discuss forward guidance — that is, how to communicate the central bank’s future plans in a way that will boost the economy today. If they want to have maximum impact, they should focus the guidance on progress in getting people back to work.
In the simplest form of forward guidance, the central bank promises not to remove stimulus — for example, by raising interest rates - before a certain date, in the hopes that the guarantee of easy money will encourage people to spend and invest. This, for example, is what the Fed did under Chairman Ben Bernanke in the first few years after the 2008 financial crisis, with some success. But there’s a problem: the central bank needs to adjust the target date whenever the economic forecast changes significantly. Given how uncertain the outlook is right now, I doubt the Fed will opt for such calendar-based guidance. The potential for sharp and frequent adjustments is just too great.
Instead, the Fed will probably use a state-based approach, in which it promises to maintain stimulus until the recovery has pushed the economy past some target, such as for unemployment or inflation. This is akin to what the central bank did — in a complicated way — from 2012 to 2014. The advantage of such guidance is that the targets don’t need to be adjusted. If well crafted, they can even act as a stabilizer: If the outlook worsens, investors will automatically expect the Fed to keep interest rates lower for longer, causing medium-term interest rates to fall and hence providing added stimulus.
The big question, then, is what the Fed should target. It could, for example, say that it won’t raise interest rates until inflation is consistently at or above the long-run level of 2%. Or it could focus on the unemployment rate, by committing to hold off on a rate hike until the unemployment rate had fallen below 4% — which is the central bank’s current forecast of long-run unemployment and the statutory target that Congress set for the Fed in the Humphrey-Hawkins Act.
As my Bloomberg colleague Tim Duy has noted, Fed communications suggest it is leaning toward inflation-based guidance. I doubt this will be very effective. True, economic models say that if consumers expect prices to rise faster in the future, they will buy more now. But recent peer-reviewed research suggests that people might actually react to news of higher future inflation by curtailing spending, perhaps because they’re concerned that their wages won’t keep up with higher inflation.
An unemployment metric, by contrast, would be unambiguous. If the Fed committed to getting the jobless rate below 4%, it would give households and businesses the confidence they needed to spend and hire. Hence, this is likely to be the most effective form of forward guidance.
Why, then, would the Fed prefer inflation-based to employment-based guidance? I see two possible reasons. First, inflation expectations have fallen markedly over the past five to six years, and the central bank would very much like to shift them back upward. But, as I said, this might have the opposite of the desired effect on spending (and hence on actual inflation). Second, at least some Fed officials might still be worried about a recurrence of the 1960s and 1970s, in which a focus on unemployment triggered unduly high inflation. But this is an infinitesimal tail risk: There’s no sign of it in the data from this millennium, either in the U.S. or in other advanced economies.
The Fed has limited firepower. It must use forward guidance to the maximum effect possible. This requires committing to keep rates low until the labor market has fully recovered.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Narayana Kocherlakota is a Bloomberg Opinion columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.
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