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Will New Federal Reserve Strategy Help Businesses Plan?

by Morris Davis Wednesday, December 19, 2012

On Wednesday, December 12, 2012, the Federal Reserve announced that it would keep interest rates close to zero until unemployment falls to at least 6.5 percent and inflation is forecast to stay below 2.5 percent. We talked about this decision with Morris Davis, James A. Graaskamp Chair in Real Estate and associate professor in the Department of Real Estate and Urban Land Economics at the Wisconsin School of Business. Before joining the Wisconsin School of Business, Davis was an economist at the Federal Reserve in Washington, D.C. For a recent NPR interview with Professor Davis, click here

WSoB: Until fairly recently, central bankers believed that it was best to be secretive about monetary policy decisions. Why is the Fed being more transparent about its policies now?

Professor Davis: The U.S. economy is hit by different kinds of shocks—such as oil price shocks or farm price shocks—fairly frequently. Policymakers have never really articulated rules for interest rates because they wanted to have some flexibility as to how they responded to these different types of shocks. That flexibility was called discretion. And many central bankers feel that discretion is very important because it gives them the flexibility to respond to any kind of shock. But there’s another group of central bankers who believe that the cost of discretion is uncertainty, and that people don’t like uncertainty. Uncertainty is bad, typically, for planning. People want some certainty before they buy a house; businesses want some certainty before they invest in capital or hire workers. So, the cost of discretion is that firms and households become less certain about what the Federal Reserve is going to do. When Federal Reserve Chairman Ben Bernanke was an academic, he advocated for much more certainty about what the Fed was doing. He believed that the Fed should explicitly announce policy targets. There can still be discretion about how to achieve those targets, but there should be policy targets, such as a desired inflation rate or a desired unemployment rate. So I think what we’re witnessing today is just a step toward adding more certainty in the way the Fed is thinking about things, but still allowing the Fed discretion as to how to get there. 

WSoB: Are there any downsides to the new Fed strategy?

Professor Davis: Yes, there are some downsides. The Fed has announced that it will keep interest rates low as long as the inflation rate is less than 2.5 percent and the unemployment rate is greater than 6.5 percent. I think the uncertainty is about the interpretation of the announcement. Does that mean the Fed is going to raise rates as soon as unemployment is less than 6.5 percent or as soon as inflation is more than 2.5 percent? Suppose the unemployment rate is 6.4 percent, but the reason is because people have stopped looking for work, so they are technically not unemployed but they still do not have jobs. Does that mean rates are going to go up immediately? I think the Fed has created some uncertainty with this announcement because people aren’t really sure how to interpret it. I predict that in the future the Fed will try to add more clarity to statements like this. 

WSoB: What kinds of changes in consumer and investor behaviors might occur after the Fed’s most recent announcement?

Professor Davis: Well, let’s talk about investors and firms first. The Fed had stated that it was going to keep interest rates low through 2015. Not a lot of people liked that statement because it wasn’t something the Fed could credibly commit to. If inflation was very high in 2013, say, the Fed would raise rates in 2014 and that would be contrary to what it stated earlier about keeping rates low through 2015. So nobody thought the Fed could credibly commit to that policy. Now, the Fed has given us a policy that we think it can commit to, and now that we understand that policy, firms should be somewhat better able to plan. 

Of course, for all of the certainty that the Federal Reserve is creating, Congress and the President are creating lots of uncertainty with the way they are handling the so-called “fiscal cliff.” So it is quite conceivable that whatever the Fed does or announces over the next year, if we can’t resolve the fiscal cliff problem, we could very well be in a recession next year.

WSoB: What are the forecasters you follow saying about the jobs outlook for 2013?

Professor Davis: It all comes down to the fiscal cliff for 2013. If we can get the compromise that everyone hopes we get, or some flavor of it, then I think a reasonable expectation is that employment will grow at an average rate of 150,000 jobs a month for the year. It might go as high as 200,000 or as low as 120,000. But if the fiscal cliff is not resolved, if tax rates go up and the payroll tax goes up and all kinds of other taxes go up next year, then hiring is going to slow and we run the risk of falling into a recession.