Fed factor

The idea of the Fed lowering the unemployment threshold from the current 6.5% has once again gained traction with expectations aided by separate studies from two top Fed economists are to be presented at the IMF’s annual research conference on November 7–8.

The importance of a focus on a lower unemployment threshold is twofold in that:

1) when it comes to monetary stimulus strengthening the forward guidance is seen as a more useful policy tool than further QE, and

2) it suggests that we should not completely dismiss the Fed tapering as early as December.

Ahead of the September FOMC meeting we talked about the elevated importance of forward-guidance language as the Fed tapers QE. The need to disconnect the markets’ view on the outlook for unconventional policy from conventional policy was clear since the Fed started to talk about tapering risks in May. It was something that forced the BoE and ECB to adopt its own forward-guidance language in July to try and insulate their money markets from the steepening on the US dollar money market curve.

The lead authors of the two separate studies are William English and David Wilcox. Both argue that a lower unemployment threshold can help counteract any tightening of financial conditions due to tapering QE (see links below).

Quelling QE

What is interesting is that the papers de-emphasise QE as a tool for achieving the Fed’s goals on unemployment and inflation. This is a theme that WSJ’s Hilsenrath touches on in his latest musings, pointing to a paper by NY Fed researchers this week that found rate guidance effective in shifting market expectations and a SF Fed paper earlier in the year which held that rate guidance is a more powerful tool than QE.

The two new Fed studies by English and Wilcox provide intellectual support for lowering the threshold beyond any concerns from within the Fed over how this might impact on its credibility. The importance of the 6.5% unemployment threshold has already been diluted by Fed officials with Fed’s Evans (of the Evans rule that eventually gave us numerical thresholds) telling us in early September that he could “easily envision certain circumstances in which the unemployment rate could go below 6% before we moved the funds rate up”.

It is likely that if the Fed chooses to lower the unemployment threshold then this will be set at 5.5% from the current 6.5% but an announcement will also coincide with a lower threshold on inflation of 1.5% as well as the current higher threshold of 2.5%.

Tapering at the December FOMC meeting is not an insignificant risk especially as the loosening of financial conditions since September has been sustained.

However, we still see the central scenario being that the Fed will choose to taper at the March FOMC meeting and likely adjust the numerical thresholds for unemployment and inflation to keep financial conditions from tightening.