Today’s news from the Fed is that they will continue their zero interest rate policy (ZIRP) until the unemployment rate falls to 6.5%. To be precise, the Federal Open Market Committee (FOMC) announced that they believe the current 0 – 0.25% range for the federal funds rate “will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
This replaces the Fed’s statement from six weeks ago, which was that they expected to continue the ZIRP “for a considerable time after the economic recovery strengthens” and said they thought the ZIRP would continue at least through mid-2015.
I think the new policy is better, first of all because it’s specific. Of course they’re going to raise rates when the economy’s better, but how do they define better? They just told us — 6.5% unemployment (it’s now 7.7%).
The new statement also is better because it’s a fairly clear policy rule, tied to an actual, observable number, as opposed to a prediction about when the ZIRP medicine will no longer be needed. Including a date like mid-2015 is problematic partly because predictions have a way of being wrong, but also because they have a way of creating bubbles. “Through mid-2015″ was widely reported not as a prediction but as a fixed commitment by the Fed, which it wasn’t. If enough people in the financial community believe the Fed will keep rates low through mid-2015, there could be a problem. Because if they know that short-term interest rates will be low for the next three years, then they may be more likely to borrow massively in the short-term money market and invest it in longer-term risky assets while rolling over their short-term debts for the next three years. (Some people say we’re already in a stock-market bubble right now, thanks to today’s low interest rates.) Granted, “borrowing short and lending long” is what banks do, but usually it’s without the certainty of near-zero interest rates for the next three years.
So I like the new policy, but one could ask if it’s too loose. ZIRP was implemented in December 2008 when the economy was in free fall and unemployment was rapidly rising, continued through our worst sustained period of high unemployment since the Great Depression, and is still in effect today, when unemployment is still very high but no higher than during much of the early 1980s and some of the early 1990s:
The Fed did not cut the fed funds rate to zero in either of those episodes, and some doubt that it makes sense now either:
But inflation was still a big concern in the early 1990s and the big concern in the early 1980s, whereas it isn’t now. Inflation has been under the Fed’s 2% target for the past three years:
Another big difference is the cause of the slump. Both of the earlier ones were largely caused by the Fed itself, raising interest rates to counter inflationary pressures and establish its credibility as an inflation fighter, whereas the current slump was preceded by almost two decades of low inflation. This slump is the result of a severe financial crisis, and economies tend to recover much more slowly after financial crises. 6.5% was the unemployment rate shortly before the ZIRP began, so it seems like a reasonable target for when the ZIRP should end.