10 years ago this month, the Fed added outcome-based forward guidance to its policy statement.
“The Committee decided to keep the target range for the federal funds rate at 0 to 0.25% and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6.5% percent,” the Committee, then chaired by Ben Bernanke, said, in the statement released following the December 2012 meeting.
There were other conditions. Rates would stay “exceptionally low” as long as “inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2% longer-run goal, and longer-term inflation expectations continue to be well anchored,” the statement read.
Explicitly tethering forward guidance to economic conditions as opposed to the date-based forward guidance the Committee employed in 2011 and 2012 came, in part anyway, at the urging of Charles Evans. The 6.5% unemployment threshold the Fed settled on was known as “alternative B” during the policy deliberations. The transcript of that meeting found officials debating staff simulations, one of which projected that the unemployment rate would fall to “about 6.5% by the end of 2015,” when inflation would be running “somewhat below” 2%.
Parsing the nuance in forward guidance (the fine art of Fed tasseography) was still relatively new to market participants in 2012. Assessing forward pricing for inflation isn’t especially complicated, and there was no mystery about what would and wouldn’t count as “well anchored” longer-term inflation expectations, but it sure was easier for markets to simply fixate on the 6.5% unemployment threshold. There was nothing ambiguous about that. The lack of ambiguity ended up being a liability for the Fed.
At the time, unemployment was 7.9%. So, 6.5% probably seemed a distant prospect. At the least, it allowed plenty of runway for policy to stay accommodative. Three years of runway, according to the staff projections, which meant that the timeline for raising rates was unchanged. At the October 2012 meeting, for example, the Fed’s forward guidance said that, “[T]he Committee… currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.”
Fast forward to December of 2013 (so, just 12 months later), and the unemployment rate, at 6.7%, was knocking on the Fed’s forward guidance door. That was a problem. Because the Fed didn’t want to raise rates yet. It was two whole years too early.
The December 2013 statement language hardly resolved the issue. Instead, the Fed just kicked the can, citing its assessment of “other information, including additional measures of labor market conditions” in suggesting that it would “likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5% especially if projected inflation continues to run below the Committee’s 2% longer-run goal” (emphasis mine).
One of Janet Yellen’s first tasks as chair involved figuring out what do with the stale forward guidance around the jobless rate. The statement that accompanied her first meeting as Bernanke’s successor didn’t exactly settle it. “With the unemployment rate nearing 6.5%, the Committee has updated its forward guidance,” the final paragraph of the March 2014 policy statement said. “The change in the Committee’s guidance does not indicate any change in the Committee’s policy intentions as set forth in its recent statements.”
The 6.5% threshold disappeared from the policy statement at Yellen’s second meeting as chair, in April 2014, replaced by this: “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.” As it happened, April 2014 was the month the jobless rate moved below the 6.5% threshold, falling a half-point to 6.2%.
Spoiler alert: The Fed, emboldened by the absence of inflation, let the unemployment rate fall all the way to 5% before raising rates. It continued to fall throughout a modest hiking cycle and a short-lived run of easing, ultimately reaching 3.5%, where it sat on the eve of the pandemic.
Jerome Powell’s trials and tribulations in 2018, and the associated market tumult notwithstanding, that period (a yearslong stretch during which policymakers had carte blanche to let the jobless rate fall ever lower thanks to cooperative inflation outcomes) was good to investors. Yellen’s tenure as chair included the halcyon days of the short-vol trade.
That 600-word trip down memory lane could be useful for thinking about 2023. Rather than allowing the unemployment rate to fall further than they imagined it could without risking a meaningful uptick in inflation (as the Bernanke, Yellen and pre-pandemic Powell Fed did), the post-pandemic Powell Fed may find itself compelled to force the unemployment rate higher than they imagined it would need to go to effectuate a meaningful downtick in inflation.
The Fed’s attempt to utilize a 6.5% unemployment rate threshold for rate hikes didn’t work in part because the assumed tradeoff between a lower jobless rate and inflation didn’t hold. The unemployment rate kept falling, but inflation habitually undershot. A less polite way of describing that conjuncture is to say that economics isn’t a hard science, which means forecasting with precision is difficult, if not mostly impossible. That, in turn, means policy settings based on forecasts will almost surely need to be adjusted to account for the (very) high odds that the forecasts are wrong.
During the period briefly revisited above, all of that was favorable for markets. The Phillips curve was either out of style or extinct depending on who you asked, so the Fed was free to keep policy accommodative on the excuse that inflation was tepid and growth mediocre, at best. We still don’t know whether the Phillips curve is alive or dead, but if price growth proves stubborn in 2023 and a decline in job openings doesn’t pay the kinds of inflation-moderating dividends Powell expects, policymakers may be forced to consider the possibility that there is still a tradeoff between jobs and inflation. Such a realization would bode poorly both for the economy and markets.
“[Some] argue that the Phillips curve still lurks in the background and could reemerge at any time to exact revenge for low unemployment in the form of high inflation,” Powell said, during an October 2018 speech in Boston. “At the risk of spoiling the surprise, I do not see it as likely that the Phillips curve is dead, or that it will soon exact revenge,” he added.
