FOMC’s Six-Month Rule: Some Background

March 15, 2010

The Federal Open Market Committee will release a new policy statement at around 18:15 GMT on Tuesday.  Analysts are not expecting significant changes, and the state of finance reform legislation in the senate, which would affect the Fed in profound ways, has diverted the press attention this week from the policy meeting.  That this is so indicates the Fed was successful in spinning its discount rate increase on February 18 as one of several steps to normalizing the central bank’s lending facilities and not a signal of change in the outlook of monetary policy.

The most closely scrutinized sentence in each FOMC statement is the one that provides guidance to future policy.  After the January 27, 2010 meeting, officials said

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

“Exceptionally low levels” as an expression first appeared in the December 2008 statement after the FOMC implemented its final federal funds rate reduction.  In that and the ensuing statement on January 29, 2009, the pertinent time horizon was “for some time,” and this was changed to “for an extended period of time” a year ago after the committee met on March 18 and also provided details of proposed quantitative easing that would sharply expand the central bank’s balance sheet.  This past November when the first hint came of a wind-down of quantitative easing, the federal funds policy guidance was tweaked slightly but not very substantively.  At that time, three economic conditions were identified for keeping the present 0.25% target, but no modification was made to the time horizon of “an extended period,” nor did that happen after the December or January policy meetings.

Financial market participants assume that the phrase “an extend period” will be modified about six months before the Fed funds target is actually raised.  If as expected, Tuesday’s statement leaves “an extended period” and the rest of that sentence essentially unchanged, analysts will conclude that means no rate hike before the fourth quarter of 2010 at the earliest.  The six-month rule has its basis in the Fed’s behavior from mid-2003 to mid-2004, a time when only Chairman Bernanke and the outgoing Donald Kohn among present Board Governors were on the Board.

In June 2003, the last Fed funds rate cut of an easing cycle that began at 6.5%, a drop of 25 basis points to 1.0%, was implemented.  At that time, the FOMC declared that because they saw a greater probability of a substantial fall in inflation than of any rise in inflation, concern about possible deflation would dominate their thinking for “the foreseeable future.”  That idea was clarified but not substantively changed at the August 2003 meeting to stating that “a risk of inflation becoming undesirably low remains the predominate concern for the foreseeable future.”  The following statements made no changes until two meaningful modifications were introduced in December 2003.  First, officials noted that the risks of higher and lower inflation had become “almost equal.”  Secondly, the time span portion was changed to “policy accommodation can be maintained for a considerable period.”  Six months later, the first of 17 consecutive 25-basis point increases of the federal funds rate was engineered.

Further adjustments of the wording occurred during those six months to prepare investors for the onset of tightening.  After the January 2004 meeting, the policy guidance sentence underwent another big change to “the Committee believes that it can be patient in removing its policy accommodation.”  The thrust of the remark had shifted from how long it might be before tightening began to a vaguer thought that could be also describing how aggressively accommodation removal would proceed.  Two meetings later in May 2004, officials asserted that the risks of higher or lower inflation had become fully equal and clearly were speaking only about the tightening phase when the policy guidance was changed again to “the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.”  Tightening indeed began at the next meeting, six months after the initial significant change in policy guidance.  Transparency seemingly requires that plenty of lead-time be programmed into a policy change if at all possible.

While the cast of policymakers has changed somewhat from six years ago, the Board is no more hawkish than then and will arguably become less so as President Obama fills the present vacancies.  Moreover, the condition of “low rates of resource utilization” — that his high unemployment and low capacity usage — argues in favor of gradualism.  Bottom line: the six-month rule probably is not a bad assumption, but one should keep in mind the limited historical precedent upon which it is basedA deviation from the 2003-4 script would not be shocking, and at some point officials would be smart to take a different path.  The strategy of 17 straight 25-bp rate increases stretched over two years was too slow, too steady, and too predictable, and as a consequence, regrettable credit market practices and asset bubbles were promoted.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.



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