QE taper / forward guidance / threshold inflation targeting

Sneaky stimulus by Ryan Avent

I RECOMMEND you read my colleague's assessment of yesterday's Federal Reserve statement. I think he's spot on in his comments, with one small exception. I'm not sure I agree with this:

Mr Bernanke indicated he thought the drop in inflation was due to transitory factors, such as a slowing rise in health costs,* and that it would drift back to 2%. Whether a failure to do so would cause QE to be ramped up again is unclear, but it would certainly result in a much longer period of zero interest rates. The bottom line is that an improving path for growth figured more prominently in the Fed’s thinking than the declining path of inflation.

That certainly seems like the right interpretation. Indeed, I wrote that the Fed was unlikely to taper because inflation is so low; the choice to go ahead and taper anyway certainly looks like evidence that they're not that worried about prices.

But it has also been clear that the Fed is trying to rely more heavily on forward guidance so as to free themselves from the need to continue with QE. And guidance about inflation changed yesterday in what looks to me like a subtle but important way. The first change comes at the top of the statement, where in October the FOMC said:

The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.

Yesterday this became:

The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.

The newer version (to my eyes, at least) implies that policy may change in the future specifically in order to raise inflation. The Fed has acted before to halt disinflation, but it has been reluctant to take positive steps to raise inflation that is low but stable. This suggests a slight change in tone in that direction.

That would be a thin reed to hang on if it were the only suggestive change in the statement, but later there is a change in interest-rate guidance:

The Committee now anticipates, based on its assessment of these factors, that it 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 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.

This is very close to adoption of an interest-rate threshold for an inflation minimum, something this newspaper has supported as a means to strengthen forward guidance. The taper provides one signal, yes, and had the Fed opted not to taper and explicitly linked that decision to these changes in guidance, that would have been a more powerful policy combination. But it is much harder to argue today that the Fed is not concerned about inflation below target and willing to work to raise it than it was on Tuesday. Unsurprisingly, expectations for future inflation, as measured by breakevens, jumped on the statement.

As always, one is torn between what looks like a positive evolution in Fed communication and overall timidity in policy. I'm glad the Fed is worried about too-low inflation, but then: why taper? But given central bank conservatism and an imminent change in leadership, I'm surprised the December meeting was this eventful. Perhaps—hopefully—there will be more fireworks in the New Year.

*"Mr Bernanke indicated he thought the drop in inflation was due to transitory factors, such as a slowing rise in health costs, and that it would drift back to 2%." 

He may be right. "Consumer spending on health care services grew at an annual pace of 2.7 percent last quarter, instead of 0.9 percent, as the Commerce Department had previously reported."