The Federal Reserve revamped its stimulus program Wednesday in the first meeting run by new Chairwoman Janet Yellen, continuing the “taper” of its bond-buying program while abandoning a benchmark for its policy of zero-percent interest rates that had become obsolete.
As expected, the central bank for the third meeting in a row reduced the size of its monthly bond purchases, from $65 billion to $55 billion.
The Fed also retired the 6.5 percent unemployment rate threshold for considering interest rate increases that it set under former Chairman Ben Bernanke in 2012 and instead issued a more general statement indicating rates will remain low.
The promise to forgo rate hikes until employment fell to at least 6.5 percent had lost meaning as the unemployment rate fell faster than expected from 7.9 percent to February's 6.7 percent, even as other indicators continue to show the labor market in poor health and the economy below potential.
The Fed's monetary policy committee dropped the numerical benchmark, instead stating that it will simply "assess progress — both realized and expected — toward its objectives," taking into account "a wide range of information," including both labor market and financial indicators.
The committee also maintained that it wasn't changing its intended stimulus, writing in the statement that "the change in the committee's guidance does not indicate any change in the committee's policy intentions as set forth in its recent statements."
Updating its forward guidance to reassure markets that it won’t raise rates until well after the asset purchases have ended and the unemployment rate has fallen below 6.5 percent is the conclusion of a number of Fed communications in recent months. As early as November, Bernanke sought to clarify that the central bank wasn’t trying to tighten monetary conditions, saying in a speech that the Fed will maintain zero-percent interest rates “for as long as they are needed.”
Based on market reactions, Fed officials have successfully reassured investors that falling unemployment won’t necessarily entail rate hikes. Prior to Wednesday’s announcement, markets had priced in rates only rising to 0.5 percent only in June 2015, and nearing 1 percent in December 2015. That timing is consistent with Fed members’ own projections. The Fed’s target rate has been zero percent since late 2008.
Wednesday’s announcement will reaffirm the Fed’s guidance, rather than drastically change it.
In addition to dropping the unemployment rate threshold, the Fed’s monetary policy committee also updated its projections of economic growth, unemployment and inflation. It now projects growth to be slightly slower than before, while anticipating a steeper decline in the unemployment rate.
According to those projections, the Fed now expects interest rates to remain lower than previously thought, even after the first rate hikes and the economy returns to full strength. Most members continue to expect the first rate hike in 2015.
One challenge facing Yellen is how to steer monetary policy while lacking clear information about the true underlying health of the labor market.
Yellen has said that the unemployment rate published by the Bureau of Labor Statistics is “probably the best single indicator” of the jobs outlook.
Falling labor force participation, however, has cast some doubt on the usefulness of the unemployment rate as it falls toward the 5-6 percent range that the Fed has said is consistent with full employment. At an early March event, Federal Reserve Bank of New York President William Dudley cautioned that “the decline of the unemployment rate significantly overstates the degree of improvement in the labor market.”
At roughly 63 percent, the labor force participation rate is the lowest it has been since the late 1970s, but it's not clear to what extent that decline reflects secular trends, such as the retirement of the baby boomers. Taking into account workers who have dropped out of the labor force after becoming discouraged in the job search, however, the Congressional Budget Office estimates that the U.S. economy is roughly 6 million jobs short of full health.
“They believe that the unemployment number isn’t adequately capturing the true conditions in the labor market,” Cumberland Advisors economist and former Fed official Bob Eisenbeis told the Washington Examiner.
Yet, Eisenbeis explained, “there isn’t another number that does it either as an alternative,” raising the need for purely qualitative guidance.
One member of the rate-setting committee, Minneapolis Fed President Narayana Kocherlakota, dissented from Wednesday's statement, on the basis that it "weakens the credibility of the committee's commitment to return inflation to the 2 percent target from below and fosters policy uncertainty that hinders economic activity."
Slow job growth in recent months was in part a product of unfavorable weather, the Fed said in its statement and Yellen affirmed in a press conference. Although non-farm payrolls grew by just an average of 130,000 in the past three months, well below the roughly 185,000 average that had prevailed since the jobs recovery began in late 2010, the Fed doesn't take that as a sign that growth has significantly slowed.
The weather "made assessing the underlying strength of the economy especially challenging," said Yellen. She later added that "weather has played an important role in weakening economic activity" in the first quarter, even though it was "not the only factor at work.”