There seems to be a belief in the markets that the earlier the Federal Reserve stops its bond purchases, the sooner it will start hiking up short-term interest rates as well.
It is hard to understand, though, why investors seem to think that. Not only has Fed Chairman Ben Bernanke indicated that the federal funds rate will probably stay at rock bottom until 2015 in his latest public communication, but Vice Chair Janet Yellen, who is the front-runner to succeed him if he leaves in January, would be least likely to hike up short-term rates prematurely.
Let’s look at what Bernanke said first. Back in December, the Fed said it would hold the target short-term rate steady at least until unemployment had dropped to 6.5%, assuming inflation didn’t rise past 2.5%. Speaking to reporters on Wednesday, Bernanke spent considerable time on the meaning of that “at least.” The 6.5% mark, he said, is the threshold that would prompt the bank to discuss the possibility of a hike. It is not a trigger that would spur an automatic decision.
The Fed’s target is achieving full employment, the situation in which every job-seeker can easily and speedily find work, which the bank believes is consistent with 5-6% unemployment (even with full-employment, goes the theory, a number of workers would be unemployed at any given time as they transition from one job to the next). The Fed could thus decide to stick to near-zero short-term rates even after unemployment has crossed the fateful 6.5% threshold. Indeed, the consensus at the bank might be shifting in favour of doing precisely that. Even though the Federal Open Market Committee (FOMC), the Fed body that sets monetary policy, projected that unemployment could hit 6.5% as early as year, in the most optimistic scenario, most FOMC members thought short-term rates should start climbing later, in 2015.
Unlike most central banks, the Fed has two mandates, as Bernanke likes to remind reporters. The first is the classic one: To foster price stability. The second one is to promote full employment. And Bernanke has made very clear that the Fed is not worried about inflation right now. Why would it be in any rush to raise short-term rates?
It’s even more likely that the Fed will want to see the jobless rate go below 6.5% before touching the fed funds rate if Bernanke steps down in January, as seems likely, and Yellen fill his shoes.
Yellen has been a driving force behind the Fed’s strong focus on unemployment during the recovery. Last year, she led a Fed committee in charge of clarifying how the bank views its dual mandate, according to the Wall Street Journal. The document reportedly indicates that as long as inflation remains below the Fed’s self-imposed target of 2%, the bank can keep printing money to fight unemployment.
Her view, as she articulated in a speech to the AFL-CIO labor union in February, is that the spike in unemployment that followed the Great Recession was largely the result of the economic downturn, and not of a skills mismatch problem in the labour market, as some have suggested. In other words, it is a phenomenon tied to the business cycle, one that the Fed can fight by trying to jump-start economic growth with monetary stimulus.
That’s true up to a point, though. Cyclical unemployment left untreated, as Yellen and Bernanke very well know, can turn into so-called structural unemployment, as the long-term jobless see their skills deteriorate and become obsolete or lose touch with the professional networks of colleagues that could help them re-enter the labour market. Bernanke and Yellen likely feel they are in a race against the clock to fight unemployment before it becomes a chronic ailment against which the Fed has no cure.
The only reason to fear the Fed might hike up short-term interest rates any time soon is that Yellen might not become the next Fed chairman next year, assuming Bernanke goes. Central bank front-runners, after all, as Canadians should know, don’t necessarily get the top job. There is always the possibility that President Barack Obama and the U.S. Senate opt for another candidate with more hawkish views on inflation. Still, Yellen has been a powerful influence on Bernanke and, indeed, the entire FOMC. Even if she doesn’t become chairman at the next opportunity, she’ll be sitting on the Board of Governors for a good while longer.