Unconventional policy forever by Ryan Avent

THE Federal Open Market Committee concluded its two-day meeting today with a nothing-burger of a statement. Very little changed in its wording on the state of the economy, and both asset purchases and interest-rate guidance remain as they were before. Things continue on as they have. New economic projections released with the statement suggest the Fed expects a bit less output growth and a bit less inflation than it previously did over the next few years, with the unemployment rate moving toward its long run range (between 5.2% and 6.0%) a little bit faster. Nothing to see here. 

That's a problem. It's easy to lose perspective on the state of the labour market, given that our expectations slowly adjust over time and that relative to other large economies America doesn't look so bad. But the recovery is nearly four years old, and the unemployment rate remains well above the pre-recession level. And the Fed doesn't anticipate unemployment returning to its natural level until 2015 at the earliest. It should go without saying that seven full years with unemployment above normal is a sign of a pretty lousy monetary-policy performance. 

A good part of the explanation for that miserable showing can be summed up in three words: zero lower bound (ZLB). Since December of 2008, when the Fed cut the fed funds rate target to roughly zero, the FOMC has been scrapping to try and boost recovery without its favoured tool. It has had some success. But the recovery has obviously been much, much weaker than anyone would have preferred. And one can conclude, from this performance and from Fed statements, that the weak recovery is rooted in the fact that the Fed is less convinced of the benefits of the unconventional tools it has been deploying and more concerned about their risks, relative to normal interest-rate policy. 

Surely, then, the Fed is looking ahead and trying to make sure that in the future it doesn't have to use unconventional tools. Right? Not exactly. If recovery proceeds as the Fed anticipates, its interest-rate target will remain at near zero until at least 2015. Perhaps more worrying, the FOMC's best guess at the appropriate, long-run value of the fed funds rate is about 4%. That is strikingly low. In each of the past three recessions the Fed has responded by cutting the fed funds rate more than 4 percentage points. A fed funds rate at that level virtually guarantees that the next downturn will result in a relapse into ZLB territory. Unless the Fed suddenly becomes much more comfortable with unconventional policy, the unemployment rate will rise more than it otherwise would and recovery will be weaker as a result. And that's assuming that growth over the next few years actually is robust enough to allow the Fed to get rates back to 4%, which is not at all guaranteed. 

At today's post-meeting press conference, I attempted to ask Ben Bernanke whether the FOMC was concerned about the lack of a cushion between the fed funds rate and the ZLB and whether the FOMC had considered adjusting policy to address the issue—by raising the long-run inflation target, for instance. His answer, essentially, was that the Fed had only just announced its 2% inflation target and had no plans to change it. And he reckoned that weighing the costs and benefits of ZLB events with an eye toward computing the optimal inflation target was a matter for academic debate. Some research suggests that at low inflation rates an economy will hit the ZLB more often than was previously assumed, he noted, which might make the cost-benefit trade-off of a higher target more attractive. 

Fair enough; monetary economists have and will continue to debate these points. But the issue is not merely academic. Most of the other questions at the press conference concerned the problem of continued high unemployment and the Fed's assessment of the risks of unconventional policy. We are living the consequences of the ZLB and the Fed's best estimates have America right back in the same hole when the next recession hits. If the Fed is simply waiting for academia to sort things out, that's really disconcerting. Alternatively, if the Fed is actually pretty comfortable using unconventional policy and not particularly worried about rolling it out again during the next downturn then one has to ask why it isn't doing much more now to address unemployment. 

The answer doesn't have to be a higher inflation target. It can be a commitment to treat the current target more symmetrically (that is, to err above as often as it errs below). Or it could be a switch to an NGDP level target. But right now, the Fed's answer seems to be: get used to nasty recessions and insufficient monetary responses, suckers. At least until academics tell us its safe to try something new.