The Federal Reserve Gets Down to Business

At a press conference in April 2012, New York Times reporter Binyamin Appelbaum asked Federal Reserve Chairman Ben Bernanke to respond to criticism that he wasn’t doing enough to bring down unemployment. Bernanke responded:

“[T]he question is: Does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased pace of reduction in the unemployment rate? The view of the committee is that that would be very reckless. We have … spent 30 years building up credibility for low and stable inflation."

Bernanke was putting a limit on how much he would do to get the economy growing faster and unemployment down. Accepting inflation above the target rate of 2 percent, either directly through active policy or implicitly by temporarily tolerating higher inflation without raising rates, wasn’t worth it. By this point a serious critique of Federal Reserve policy had been developed by those who thought the Federal Reserve should be doing more. This held that the Federal Reserve needed to clearly state where it wanted to end up, and promise to keep policy as active as it can be until then. That involves arguing for a destination of growth and employment, and explaining what they would be willing to tolerate in higher inflation until they got there.

Yesterday, the Fed chairman changed his tune, announcing that he would be comfortable with a higher inflation rate while unemployment remains high.  Adopting what has come to be known as the Evans Rule, whereby rates remain low until either inflation hits 2.5 percent or unemployment reached their initial target of 6.5 percent, is a remarkable change. Beyond a needed expansion of monetary policy, this represents a major policy victory. How did this happen?

The Evans Rule dates from a September 2011 speech given by Charles Evans, the president of the Federal Reserve Bank of Chicago—one of the 12 regional Federal Reserve banks informally led by the New York Federal Reserve. The speech called out the Fed for not taking both parts of its mandate—to keep both inflation and unemployment low—seriously. Evans noted that unemployment was at 9 percent while inflation was near the target, and the Fed didn’t seem that concerned. But those numbers are equivalent to a situation where inflation was higher than expected, say 5 percent, and unemployment was lower, a situation where the Federal Reserve would certainly take notice. In the speech, Evans proposed that the Federal Reserve tie its projections to unemployment while also giving a clear number on the inflation rate it would tolerate. This would prevent the Federal Reserve from keeping the economy in check by its inaction.

At this point, the Federal Reserve was under significant attack from those who thought it was doing too much. Evans gave his speech a few weeks after GOP presidential candidate Rick Perry said he would “treat [Bernanke] pretty ugly down in Texas” if he did more monetary stimulus. The Federal Reserve Board had numerous dissenters who thought too much was being done and that unemployment might be stuck at 9 percent indefinitely. This speech put Evans on the map as someone brave enough to call out the Federal Reserve’s inaction. A month later, when he became the first dissenting vote on the Federal Reserve Board in favor of more stimulative action, it was clear he was someone to watch.

Around this time, Ben Bernanke tried to expand out monetary policy. He promised to keep rates low until a certain date, such as late 2014. This was designed to expand monetary policy by committing to the markets to keep rates low long enough to ensure a recovery. Evans critiqued this policy as insufficient in a Brookings Paper, criticizing its “Delphic” rather than “Odyssean” character. It’s a fairly complicated argument, but a metaphor can suffice. Picture your romantic partner saying “we need to talk tonight.” You might think that this is a great thing, because maybe you’ll have a great conversation about taking a romantic vacation together. But then you might get very anxious and worried, because maybe things are worse than you realized and you are just learning about it.

Evans basically argued that when Bernanke says rates will be low until a later date, he’s generating the “we need to talk” confusion. The market can’t tell if this change is because things will get better by the later date or because things are getting worse now. The only way for it to work is to tie rates to specific events, either unexpectedly high inflation or sufficiently low unemployment. That is what the Evans Rule is designed to do. The case for the Evans Rule continued to grow, with even people voting in favor of tightening policy in late 2011, like Federal Reserve Bank of Minneapolis Narayana Kocherlakota reversing course and supporting a version of it.

Their support, combined with one of the leading intellects in monetary economics, Columbia University economist Michael Woodford, make a very public statement that the Federal Reserve can and should be doing more, and that it needed to do more along the lines of this expectation management, finished the case, and Ben Bernanke adopted the Evans Rule.

In September the Federal Reserve embarked on a more aggressive monetary policy stance with the launch of QE3. This new policy directly addressed the criticism they were facing by announcing that policy was tied specifically on where they want end up with growth. The Federal Reserve argued it would keep rates low until a considerable amount of time after the recovery strengthens. It binds the Federal Reserve to seeing through to a full recovery, rather than either acting as a drag on it or killing it just as it starts to really get going.

The one thing missing were the hard numbers of what thresholds would cause the Federal Reserve to start to raise rates. With this announcement the new monetary regime for the recovery is in place. The Federal Reserve has taken the advice of its critics, and in a remarkably short amount of time changed how it approaches policy. The only place forward to go is to tie monetary policy to a specific level of nominal GDP, which Evans and others have suggested. The Evans Rule, if successful, could provide evidence for that approach. But the question is now: how well will this all work?

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