Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Thursday, December 20, 2012

The hawkish nature of the Evans Rule

From Bloomberg Businessweek:
The Fed Turns Aggressively Dovish with 'Evans Rule'

The headline above seems to capture the general sentiment surrounding the FOMC's recent  policy announcement. The recent move is characterized by many as "dovish" in nature because
...the Fed will keep short-term interest rates near zero as long as unemployment remains above 6.5 percent and the inflation it expects in one to two years is no higher than 2.5 percent. That replaces the previous plan to keep rates near zero until mid-2015. Given the slow pace of job growth, the current plan could mean that rates stay super-low past mid-2015.
Sure. Of course, the FOMC could alternatively have just extended the "lift off" date into the more distant future (as they have done in the past). But that's neither here nor there. What I want to talk about is the move to a state-contingent policy that makes explicit reference to the unemployment rate. St. Louis Fed President James Bullard has long advocated a move to state-contingent policy (see here). The actual form of the policy turned out to be one subsequently advocated by Chicago Fed President Charles Evans (hence, the "Evans Rule"). Maybe it's not perfect, but perhaps it's a move in the right direction.

In any case, here is the relevant part of the FOMC statement:
In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.
According to the Bloomberg article above,
This is essentially what Charles Evans, President of the Federal Reserve Bank of Chicago, has been arguing for over the last year. Dubbed the Evans Rule, the argument holds that monetary policy shouldn’t be tightened until the economy heals pasts a certain predetermined threshold.
This makes it sound like that by making explicit reference to the unemployment rate in a policy rule, one necessarily makes the rule more "dovish" in nature. A comment left by "K" in my previous post got me to thinking, however, that the opposite might be true in this case. 

To see what I mean by this, consider the following visual depiction of the Evans Rule:

 
Since near term inflation is currently projected to be less than 2.5% and since the unemployment rate is currently above 6.5%, the U.S. economy is currently located in Region 4 of the diagram above. The Evans Rule in this case says: keep the policy rate at zero (actually, 0.25%). The rule also suggests that if the economy happens to drift into any one of the remaining four quadrants, the Fed would consider increasing the policy rate.
  
What role is the 6.5% threshold playing in the Evans Rule? One could make a case that its role is to dictate a tighter monetary policy over a greater range of circumstances. 

To see this, simply ask what the diagram above would look like absent the 6.5% threshold on unemployment. Region 3 would now look like Region 4. That is, the rule would now specify that the policy rate should remain low over a greater range of unemployment rates. 

As Chairman Bernanke stressed in his press conference, the new policy does not imply that the Fed will necessarily raise its policy rate should the unemployment rate fall below the 6.5% threshold (Region 3). But surely, if the unemployment rate crosses this threshold, the perceived probability of an imminent rate hike is likely to spike up. Absent the unemployment rate threshold, the market would likely expect the policy rate to instead remain low for a longer period of time. This is the hawkish nature of the Evans rule. 

12 comments:

  1. David,

    This was exactly my thinking, and well presented.

    A minor nitpick is that I still think it's imprecise to call less than 6.5% unemployment a necessary conditioning for tightening. If tightening may occur after reaching 2.5% inflation (region 2) then low unemployment is *not* necessary.

    The power of the conjunction fallacy depends to a large extent on the the provocativeness of the red flag that you wave in people's faces. Who would imagine that "We will maintain policy accommodation so long as inflation is below two percent and Scott Sumner thinks we aren't doing enough" is actually a comparatively hawkish Fed stance.

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  2. Mmm, I would rather think that, if unemployment falls below 6.5% and inflation stays below 2.5%, the Fed would consider further lowering the unemployment limit.

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    1. That may be true but, if so, then what is the point of including the unemployment rate threshold in the first place?

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  3. Anonymous,

    Think what you want. Everyone is free to have opinions about what the Fed may or may not feel like doing at any point in the future, forward guidance or not. The issue is to what extent they have *constrained* themselves towards accomodative policy with the current statement. The answer is: less than without the unemployment clause.

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  4. This comment has been removed by the author.

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  5. sorry but could you tell me what you mean by "hawkish"? I'm new to the blog and I was expecting "hawkish" to mean "favoring war". I understand it could mean aggressiveness in general but I'm unclear as to what's meant here.

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    1. JC, in the context of monetary policy, "hawkish" refers to being more concerned about low inflation than high unemployment. See: http://www.fxwords.com/h/hawkish.html

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    2. David: you weren't clear there (unlike your lovely clear picture and post). A hawk is someone who hates high inflation and isn't very concerned about high unemployment.

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  6. Roll NGDP into the inflation calculator and see what that does to 'well anchored' longer-term inflation expectations.

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  7. I agree with K, and made a similar comment in response to Gavin Davies' FT blog post on this subject. It could be construed as hawkish.

    But note the ambiguity here. The statement is not very clear about what happens if inflation rises above 2.5% but unemployment is still above 6.5%. Hawks will want the Fed to tighten, and doves will argue for continued easing.

    Fundamentally, the problem that the Fed has is its silly mandate - or at least how its mandate is interpreted - and the Fed's own lack of courage in fighting its corner. As I understand it, a central bank has little power over real activity except in the short run, so the Fed needs to get away from ideas of inflation at one end of a scale and sluggish growth at the other end. Otherwise, they will sometimes reach positions that are apparently not on the scale. This problem is not new - I used to think the same of the old "bias" indications.

    The Fed should tell the politicians forcefully that, when it comes to real activity, it can only affect the RATE OF CHANGE of the chosen variable, and that this is how it will interpret the mandate, and if the politicians don't like it, they must use whatever powers they have to make the Fed act against its own advice. Politicians have not got the guts to risk such a confrontation, partly because they are not confident in their ability to win the argument and partly because if they did they would then be unequivocally responsible for the consequences, so I reckon that a stronger figure than Bernanke could pull it off, and the Fed could gain authority like the Bundesbank.

    But then I am just a militant former central banker.

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