The Federal Reserve Debates Tools to Combat Slowdown

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It settled on announcing its intention to keep interest rates near zero through mid-2013, but five other possibilities were also discussed

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When the Federal Reserve chose to try to stimulate the economy with its words earlier this month, the market wasn't impressed. The Fed attempted to provide investors more certainty on interest rates, saying they would remain near zero through mid-2013. But the market wanted some more tangible action, like another round of asset purchases. In the Fed's detailed August meeting minutes, we get a glimpse of how this and other tools were considered. The discussion provides a preview of how the Fed might intervene if the economy continues to struggle.

Tool #1: The Time-Based Language Tweak (what the Fed chose)

As its August 9th statement indicated, the Federal Reserve intends to leave interest rates near zero not just for a vague extended period, but through mid-2013. By providing this specificity, the Fed hopes to prevent rates from creeping up if some in the market expect them to rise sooner than the Fed might prefer.

But the Fed clarified something key about its intentions here: they aren't written in stone. The minutes say:

Most members, however, agreed that stating a conditional expectation for the level of the federal funds rate through mid-2013 provided useful guidance to the public, with some noting that such an indication did not remove the Committee's flexibility to adjust the policy rate earlier or later if economic conditions do not evolve as the Committee currently expects. (my emphasis)

In some sense, this weakens the impact of this language change. Prior to August 9th, the market knew that interest rates were going to remain very low until the economy picked up and the Fed decided that it was time to raise them. This understanding doesn't appear to have changed. But now we have a timeline for how long the Fed expects that the economy will remain too weak to accommodate an interest rate hike. The Fed does not appear committed to the mid-2013 date if conditions evolve in unexpected ways.

Tool #2: The Economic Indicator-Based Language Tweak

A different alternative was provided to the mid-2013 guidance. Instead, the committee considered basing its timeline on economic indicators. Some Fed economists suggested conditioning interest rates on "explicit numerical values for the unemployment rate or the inflation rate."

This would have been a logical way to construct the Fed's guidance. After all, what will -- and should -- ultimately control its decision to raise interest rates will be unemployment and inflation. So why not bake that into the market's guidance?

The minutes don't explain why this option was pushed aside for a date. It only says that some members of the committee "raised questions about how an appropriate numerical value might be chosen." Is it really easier to pick an appropriate date? A date actually seems far more arbitrary than saying if unemployment hits, say, 7%. Will something magical happen in mid-2013 that the rest of us don't know about that led the Fed to choose this as its date for when interest rates will finally rise?

The real reason this sort of guidance wasn't chosen is more likely flexibility concerns. The Fed could easily say in early 2013 that the economy has improved quicker than it anticipated so it is raising interest rates earlier. But it can't as easily say that it's raising rates earlier than a strict numerical trigger based on unemployment and inflation would have stipulated. This might be what those Fed economists were alluding to when they worried about appropriate numerical values. A date is easier to pull out of the air arbitrarily (and ignore) than an unemployment rate. If a numerical economic indicator is used, the Fed might have to actually explain its logic.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.
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