HEARD ON THE STREET
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Updated December 12, 2012, 6:33 p.m. ET
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Fed Chooses a New Job Description
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By JUSTIN LAHART
Most central banks are guided by a deep fear of inflation. Not the Federal Reserve, not anymore.
The Fed's dual mandate, established in the late 1970s, tasks it with keeping prices stable while keeping employment as high as possible. But for most of that time, it was prices that the Fed focused on, with the central bank focused on when to take away the "punch bowl."
A review of Fed meeting minutes, congressional testimony and policy statements conducted by St. Louis Federal Reserve economist Daniel Thornton shows that the central bank rarely broached the subject of maximum employment until the 2008 financial crisis struck.
But since then, the Fed has become increasingly focused on employment. Wednesday, it codified it, saying that it will keep rates near zero as long as the unemployment rate is above 6.5%, provided its projections for the inflation rate one and two years out aren't above 2.5%. And it will keep on buying mortgage-backed securities absent signs the job market is improving.
In other words, its actions will principally depend on a firm number, the unemployment rate, tempered by what happens to much squishier estimates about what inflation might be in the future.
In some regards, the Fed's new wording doesn't change anything. When it met in October, it said that it expected to keep rates near zero through mid-2015, and its latest projections show that Fed board members and regional bank presidents, on average, expect unemployment to fall below 6.5% sometime in 2015.
But while the change binds the Fed more firmly to what happens to the unemployment rate, it also adds some flexibility to the timing of future shifts in monetary policy. If, say, the job market improves faster than Fed officials now forecast, they will tighten sooner than 2015.
The theory behind this is that when short-term rates are near zero, putting in a specific rules-based framework for what must occur before they are raised can help to keep long-term interest rates lower for longer.
The Fed has left itself some wiggle room in how it proceeds, with Chairman Ben Bernanke specifying Wednesday that if the unemployment rate falls below 6.5% but inflation forecasts remain quiescent, the Fed might not raise rates. But the central bank has never prescribed what its future actions will be to such a detailed degree before.
The danger is that the Fed puts together inflation projections that are too rosy. Right now, the risk of that happening doesn't look that high. Inflation trends tend to change slowly, to the extent that the best way to forecast what the change in core prices will be over the next year is generally to look at the past year.
But on the off chance that the Fed does get badly surprised by rising inflation, it will have to go from an incredibly loose monetary policy to a much tighter one in an awfully big hurry.
A review of Fed meeting minutes, congressional testimony and policy statements conducted by St. Louis Federal Reserve economist Daniel Thornton shows that the central bank rarely broached the subject of maximum employment until the 2008 financial crisis struck.
But since then, the Fed has become increasingly focused on employment. Wednesday, it codified it, saying that it will keep rates near zero as long as the unemployment rate is above 6.5%, provided its projections for the inflation rate one and two years out aren't above 2.5%. And it will keep on buying mortgage-backed securities absent signs the job market is improving.
In other words, its actions will principally depend on a firm number, the unemployment rate, tempered by what happens to much squishier estimates about what inflation might be in the future.
In some regards, the Fed's new wording doesn't change anything. When it met in October, it said that it expected to keep rates near zero through mid-2015, and its latest projections show that Fed board members and regional bank presidents, on average, expect unemployment to fall below 6.5% sometime in 2015.
But while the change binds the Fed more firmly to what happens to the unemployment rate, it also adds some flexibility to the timing of future shifts in monetary policy. If, say, the job market improves faster than Fed officials now forecast, they will tighten sooner than 2015.
The theory behind this is that when short-term rates are near zero, putting in a specific rules-based framework for what must occur before they are raised can help to keep long-term interest rates lower for longer.
The Fed has left itself some wiggle room in how it proceeds, with Chairman Ben Bernanke specifying Wednesday that if the unemployment rate falls below 6.5% but inflation forecasts remain quiescent, the Fed might not raise rates. But the central bank has never prescribed what its future actions will be to such a detailed degree before.
The danger is that the Fed puts together inflation projections that are too rosy. Right now, the risk of that happening doesn't look that high. Inflation trends tend to change slowly, to the extent that the best way to forecast what the change in core prices will be over the next year is generally to look at the past year.
But on the off chance that the Fed does get badly surprised by rising inflation, it will have to go from an incredibly loose monetary policy to a much tighter one in an awfully big hurry.
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