Historically, the U.S. Federal Reserve has had one primary tool it reached for when it needed to edit the monetary environment. That tool is the raising or lowering of the target federal funds rate, which is the interest rate at which banks will trade federal funds.
This rate serves as a benchmark for most other interest rates throughout the financial market. When it is lowered, interest rates in general tend to decrease; when it is raised, interest rates tend to increase. Low interest rates help stimulate economic activity by encouraging borrowing and spending, as businesses can more easily access credit to buy capital or expand payrolls, and consumers can access cheaper loans for automobiles or home purchases. Higher interest rates tend to have the opposite effect, restricting the flow of credit by increasing its price.
This tool, simple as it may seem at first glance, is enormously powerful. In many ways, interest rates are the beating heart of the financial sector, and the Fed has its hand wrapped tightly around the muscle. The federal funds rate in particular can be used as a liquidity throttle. This is why in 2008, as the financial crisis wreaked wanton destruction through the banking system and credit markets began to seize, the Fed slashed the federal funds rate to the zero bound, hoping to stimulate business activity in interest rate sensitive sectors.
The strategy has worked, to a degree. Monetary policymakers have argued that although the economic recovery has been weak over the past few years, the only reason there is a recovery at all is because of accommodative monetary policy. Perhaps most importantly, interest rates have helped fuel the recovery of the housing market, which has been a cornerstone of the overall economic recovery.
But as the recovery progresses, the effectiveness of monetary policy at the zero bound has been called into question. With the throttle opened all the way, the Fed has resorted to extraordinary and unconventional measures to stimulate economic activity, actions that have caused no shortage of controversy.
Quantitative easing — the purchase of assets in the open market aimed at reducing longer-term interest rates — has attracted criticism and even ire from opponents of the program. Such purchases, although effective at putting downward pressure on interest rates, arguably foster financial instability by expanding the Fed’s balance sheet and by encouraging investors to tolerate more risk in their search for yield.
Along with its impact on interest rates, quantitative easing drives down currency valuations (which impacts imports and exports), increases inflation expectations (although inflation is pretty much nowhere to be found at the moment), and increases equity valuations. Quantitative easing impacts pretty much every corner of the vast financial market, which means that any changes to the program will impact pretty much every corner of the vast financial market.
This is not news, though. Equity markets around the world threw two so-called “taper tantrums” over the summer, when former Fed Chair Ben Bernanke simply alluded to the possibility of tapering occurring within the calendar year. Equities plunged and interest rates soared during these periods as the markets braced for withdrawal from the monetary stimulus they have become addicted to. When it became clear that the Fed was not yet prepared to taper, assets regained their value and interest rates moderated.
Although the taper has now been implemented without any real problems, the tantrums demonstrated that the Fed’s greatest remaining challenge is actually one of communication. As Charles Plosser, president and CEO of the Federal Reserve Bank of Philadelphia, said in a speech he delivered at the University of Chicago Booth School of Business at the end of February: “Communication and transparency have been important themes in monetary policy discussions over the past decade or more. … In part, this emphasis on communication and transparency reflects the steady evolution in the theory and science of monetary policy.”
The Fed’s communication strategy has been tied up under a policy called forward guidance. “Forward guidance seeks to inform the public about the future path of policy rather than describing a policy action taken today,” said Plosser. “Thus, effective forward guidance is all about communication and what it conveys or doesn’t convey.” To put it another way, forward guidance is about managing expectations. Markets generally only throw a tantrum when reality does not match expectation. The great challenge, of course, is that predicting economic reality is enormously difficult, bordering on impossible.
The Fed has targeted 6.5 percent unemployment in a context of price stability as threshold beyond which policy change is possible, but this target is seen by many as increasingly useless. Headline unemployment fell to 6.6 percent in January but job growth has been weak and labor force participation has declined, making the headline rate a poor reflection of of the actual health of the labor market.
“Why is the 6.5 percent unemployment rate important?” asked Plosser. “Because the Committee made it important. The Committee, in essence, told the markets that the 6.5 percent unemployment rate was an important quantitative marker. … Yet, the 6.5 percent threshold will soon become irrelevant, and it probably is already.” Because of superficial downward pressure, headline unemployment fell more rapidly than anticipated. Soon, the threshold will be passed, but the Fed won’t be able to toggle its target federal funds rate because QE is ongoing.