Economists At The Cleveland Fed Have Found A Powerful New Way To Augment Forward Guidance

One of the big questions that emerged from the minutes of the Federal Open Market Committee's October meeting was how the Federal Reserve's monetary policymaking body could reinforce the forward guidance it offers on the likely future path of short-term interest rates.

Current guidance dictates that the central bank will not raise the benchmark fed funds rate from its current target level between 0 and 0.25% until the unemployment rate falls below 6.5%.

Yet the Fed is also buying $85 billion of bonds each month under its quantitative easing program, which the Committee would like to wind down soon in favor of relying more heavily on forward guidance to continue stimulating the economy.

Developments in recent FOMC communications have led Wall Street economists to predict that the Fed will look to augment its forward guidance around the time it begins tapering down its bond buying program in order to quell volatility in financial markets.

The latest minutes revealed, however, that the Committee hadn't yet figured out at the time of its October meeting the best way to implement such a change.

A new analysis released today by economists at the Cleveland Fed suggests that adding a 1.75% inflation floor to the Fed's 6.5% unemployment threshold would likely delay breaching of forward guidance thresholds by a year.

The basic finding of the study, according to Cleveland Fed vice president Edward S. Knotek II and senior economic research analyst Saeed Zaman: "The joint probability of breaching either the unemployment threshold or the inflation threshold and at the same time satisfying the inflation floor first crosses 50 percent by 2016:Q1, a four-quarter delay compared with the case without an inflation floor."

After taking into account the range of possible outcomes, the most likely outcome based on our model is that at least one threshold for raising the funds rate will be satisfied as of 2015:Q1. We show that this is two quarters earlier than if we were to look at the outlook for unemployment and projected inflation separately.

"Our model can also consider the impact of changes to the forward guidance, such as introducing an inflation floor," write Knotek II and Zaman. "An inflation floor of 1.5 percent would have a modest impact on the probability of satisfying both the floor and at least one of the thresholds, while an inflation floor of 1.75 percent could delay the point at which both the floor is satisfied and a threshold is crossed by about one year. This exercise suggests that the choice of an inflation floor could exert a considerable delay on the liftoff of the federal funds rate from the zero lower bound."

The Cleveland Fed economists say whether or not the FOMC adds an inflation floor to its suite of forward guidance, the "single most likely scenario" according to its forecasts is that the 6.5% unemployment rate threshold will be breached in the third quarter of 2015.