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Two Policy Instruments,

Two Labor Market Thresholds
T. Rowe Price
By Alan Levenson
November 9, 2012


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  • Despite understandable post-election focus on the resolution of the looming fiscal cliff, there is persistent interest in the conditions under which the FOMC will end the asset purchase program initiated in September (“QE3”). The level of the unemployment rate conditions the decision to begin raising the fed funds target rate, while the rate of change in the unemployment rate will guide adjustments to the asset purchase program.
  • The economic projections and monetary policy expectations submitted for the September 12-13 FOMC meeting indicate that a consensus for rate hikes begins to build as the unemployment rate approaches 7.0% (Figure 1). Our reading of Bernanke’s September 13 remarks is that the threshold for winding down open-ended asset purchases is several (at least three) quarters of monthly employment gains in a 150,000-175,000 range, sufficient to reduce the unemployment rate by ½ percentage point per year.
  • Combining these parameters with our economic outlook, we expect the Fed to announce on December 12 a $45 billion per month program of Treasury securities purchases to maintain the current $85 billion after the Maturity Extension Program expires at year-end. This pace will be sustained at least through mid-2013, with a gradual and amply-signaled tapering to begin before the end of 2013. In this event, total securities purchases under QE3 could exceed $750 billion.

Singular focus within the dual mandate
The Fed is bound by law to pursue a “dual mandate” of maximum employment and price stability. Price stability is defined qualitatively as a rate of inflation sufficiently low and stable that it is not a factor in business decisions; the FOMC has quantified price stability with a 2% long-run objective for inflation in the personal consumption expenditures (PCE) price index. Maximum employment (minimum unemployment) is the greatest (lowest) attainable without generating inflation pressures in violation of the price stability objective. The FOMC’s 5.6%1 longer-run forecast for the unemployment rate, representing the Committee’s collective estimate of the NAIRU (Non-Accelerating Inflation Rate of Unemployment), quantifies maximum employment.

The Fed has deployed two policy instruments in pursuit of its mandated objectives: the fed funds target rate and the Fed’s balance sheet. Each has quantitative and qualitative components. The Fed is broadly meeting its inflation objective: deflation risks that emerged in the 2008-2009 recession have been dispelled, and PCE inflation of 1.7% is close to, but still below, the long-term objective. In contrast, the 7.9% unemployment rate is far from the Fed’s collective view of full employment, so both of the above mentioned policy instruments have been directed toward achieving greater progress on this side of the Fed’s mandate.


Rate hike conditioned on unemployment rate level

Interest rate guidance – the span over which the FOMC expects to maintain the current 0%-0.25% fed funds rate – has been conditioned centrally by the unemployment rate: until it approaches the NAIRU, monetary policy need not begin the adjustment from the extreme of policy accommodation embodied in the current fed funds rate to a broadly neutral stance.2 Projections prepared for the September 12-13 FOMC meeting suggest that a consensus for a raising rates only begins to gain strength as the unemployment rate approaches 7% (Figure 1).


Asset purchases conditioned on the rate of change
The latest round of asset purchases was initiated due to a lack of progress toward the Fed’s maximum employment objective: “[T]he Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions”.3 Asked to define “sustained improvement,” Chairman Bernanke indicated that, although “[T]here’s not a specific number we have in mind,…what we’ve seen the last six months4 isn’t it. We’re looking for something…that involves unemployment coming down in a sustained way.”5


Thus, while the decision to raise the fed funds rate depends on the level of the unemployment rate, the course of the open-ended program to purchase $40 billion per month of agency mortgage-backed securities (“QE3”) announced on September 13 depends on its rate of decline. As Chairman Bernanke put it in describing conditions under which the Fed would suspend asset purchases:


[w]e’re not going to be able to sustain purchases until we’re all the way back to full employment; that's not the objective. The idea is to quicken the recovery, to help the economy begin to grow quickly enough to generate new jobs and to reduce the unemployment rate.6


How much, for how long?
In light of the structural impediments to faster growth, we believe that the Fed would be satisfied with employment growth of 150,000-175,000 per month, which we estimate would reduce the unemployment rate by ½ percentage point per year. Yet policy makers also want to be sure that this rate of labor market healing has solid internal momentum. In our judgment, the Fed will want several quarters (not less than 3, starting with the current quarter) of evidence that this is the case, including a confirming pace of demand and production (GDP) growth that justifies the addition of labor input.


Thus, we expect the FOMC to announce on December 12 an open-ended $45 billion per month program of Treasury securities to maintain the $85 billion pace of securities purchases – $40 billion of MBS in QE3 and $45 billion of Treasury securities in the Maturity Extension Program (MEP) – after the MEP expires at year end. This pace of asset purchases will continue through the first half of next year, in our view, with a gradual and amply-signaled tapering to begin before the end of 2013. In this event, total securities purchases under QE3 could exceed $750 billion.

 

1 The midpoint of the range of FOMC members’ latest forecasts. “Longer-run projections represent each participant’s assessment of the rate to which…[the unemployment rate] would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy.” (“Minutes of the Federal Open Market Committee”, September 12-13, 2012.

2 Which the FOMC estimates at roughly a 4% fed funds rate, based on the forecasts prepared for the September 12-13 FOMC meeting.
3 “Press Release,” Federal Open Market Committee, September 13, 2012.
4 In the six months leading up to the September 13 announcement of QE3, employment growth in the Labor Department’s household survey (on which the unemployment rate is based) averaged just 6,000 per month (employment in the survey of nonfarm payrolls averaged less than 100,000 per month). The unemployment rate had fallen 0.2 percentage points (pp), but largely due to a 0.3 pp fall in the labor force participation rate.
5 Ben S. Bernanke, “Press Conference,” September 13, 2012, transcript provided by Roll Call, Inc., via Bloomberg.
6 ibid.

 

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