My own view is that these thresholds should act similar to triggers. So once the [unemployment] rate nears 6.5 percent, markets and the public should expect lift-off of short-term interest rates.

In my view, rather than try to maintain discretion, policymakers would achieve better economic outcomes and greater clarity by taking a systematic approach to policy. But how do we get there from here? I think we could vastly improve policy going forward by doing three things, which would begin to normalize monetary policy.

• The first step is to wind down our asset purchases by the end of the year in a gradual and predictable manner. As I said, I see little if any benefit from these purchases, and growing costs.
• The second step is for the FOMC to commit to its forward guidance on the fed funds rate path, that is, to begin treating the 6.5 percent unemployment rate and the 2.5 percent inflation rate in the guidance as triggers rather than thresholds.
• The third part of the strategy is to provide information on how our interest rate policy will evolve after the trigger is reached. A commitment to a robust policy rule, perhaps consistent with the way policy was conducted prior to the crisis, would provide needed clarity on how the Committee intends to vary its policy in response to changes in economic conditions.

These steps form part of a systematic approach to policymaking. They embody clarity and commitment. By helping the public and market participants form more accurate judgments about the future course of policy, systematic policymaking can improve the efficacy of monetary policy.

In August 2011, the Committee began using dates to signal when the policy rate might increase, but it changed those dates at subsequent meetings. The FOMC then opted to formulate its forward guidance in terms of thresholds for unemployment and inflation. This is preferable to calendar dates because it is state contingent. Yet, the FOMC has specifically said that the thresholds are not triggers — they are not firm commitments and they may change. The Committee has repeatedly opted for language that allows a great deal of discretion to behave as it chooses, depending on the circumstances. But effective forward guidance demands commitment. When the Committee stresses the general flexibility of its policy decisions or makes vague references to data dependency, it does little to clarify the FOMC's intentions about future policy, even though clarity is what the FOMC wants to provide to the markets through its forward guidance. Thus, there is a fundamental tension between wanting to provide clarity as to the forward course of policy and wanting to maintain complete discretion. The Committee has failed to address this tension, which undermines the effectiveness of its policy.

I would add that this tension is not new. The Committee has typically preferred discretion over systematic policy. Yet, in normal times, the conduct of policy was more predictable and the public had come to expect policy to play out in mostly understandable ways. Since the crisis, the old "rulebook," so to speak, has been thrown out, but we haven't replaced it with anything except some vague promises that have changed over time. This naturally leads to a lack of clarity in the eyes of the public and undermines the effectiveness of the forward guidance the Committee offers.

In my view, rather than try to maintain discretion, policymakers would achieve better economic outcomes and greater clarity by taking a systematic approach to policy. But how do we get there from here? I think we could vastly improve policy going forward by doing three things, which would begin to normalize monetary policy.

• The first step is to wind down our asset purchases by the end of the year in a gradual and predictable manner. As I said, I see little if any benefit from these purchases, and growing costs.
• The second step is for the FOMC to commit to its forward guidance on the fed funds rate path, that is, to begin treating the 6.5 percent unemployment rate and the 2.5 percent inflation rate in the guidance as triggers rather than thresholds.
• The third part of the strategy is to provide information on how our interest rate policy will evolve after the trigger is reached. A commitment to a robust policy rule, perhaps consistent with the way policy was conducted prior to the crisis, would provide needed clarity on how the Committee intends to vary its policy in response to changes in economic conditions.

Currently, we have an unemployment rate of 7.6 percent, which I think, if anything, overstates the health of our labor markets given participation rates and many other indicators of underemployment and long-term unemployment. So we’re not there, obviously, on the maximum employment part of the mandate.

…

There will not be an automatic increase in interest rates when unemployment hits 6.5 percent. Instead, that will be a time to think about the situation anew. And given, as I said, the weakness of the labor market, the fact that the unemployment rate probably understates the weakness of the labor market, given where inflation is, I would suspect that it may be well sometime after we hit 6.5 percent before rates reach any significant level.

In response to a question about whether the Fed’s communications innovations will be permanent or not.

Well, I think most of the things that we’ve done will likely be permanent, not — of course, a future committee might decide to make changes to our projections or changes to the way we structure our minutes, or other things that certainly could happen. I think that, you know, the definition of price stability and the longer-run policy strategy, I’m hopeful that will be a long-lasting innovation.

The communications that are specifically related to the zero lower bound are particularly the forward guidance, where we’ve tried to provide not targets, not objectives, but rather guideposts to help the markets understand and the public understand, you know, when we expect policy to begin to change.

It may be that when we leave the zero lower bound and when the economy is in a more normal configuration, that that kind of guidance won’t be necessary anymore, because as was the case prior to the crisis, the markets can just look at the behavior of the Fed and essentially extrapolate that behavior to understand what the Fed is likely to do as the economy evolves.

That being said, there may be circumstances where this kind of guidance is helpful, and I just note that we’re seeing — the Fed Reserve, by the way, was not the first to use this kind of guidance. I just want to be clear that, you know, the Bank of Japan, the Bank of Canada have experimented with these types of ideas as well. And I think it’s becoming an international practice that — to various degrees in various places, but I suspect that we’ll see its use in some context at least going forward. But I don’t think it’s necessarily a permanent part of Fed Reserve policy, precisely because we will be moving away from the zero lower bound. And, I hope, we’ll — you know, in a reasonable period of time, we’ll be in a more normal monetary environment.

The framework for implementing monetary policy has evolved further in recent years, reflecting both advances in economic thinking and a changing policy environment. Notably, following the ideas of Lars Svensson and others, the FOMC has moved toward a framework that ties policy settings more directly to the economic outlook, a so-called forecast-based approach. In particular, the FOMC has released more detailed statements following its meetings that have related the outlook for policy to prospective economic developments and has introduced regular summaries of the individual economic projections of FOMC participants (including for the target federal funds rate). The provision of additional information about policy plans has helped Fed policymakers deal with the constraint posed by the effective lower bound on short-term interest rates; in particular, by offering guidance about how policy will respond to economic developments, the Committee has been able to increase policy accommodation, even when the short-term interest rate is near zero and cannot be meaningfully reduced further.The Committee has also sought to influence interest rates further out on the yield curve, notably through its securities purchases. Other central banks in advanced economies, also confronted with the effective lower bound on short-term interest rates, have taken similar measures.

Bernanke had emerged from the June 19 meeting to say the central bank expects to reduce the pace of purchases later this year and to halt the program altogether midway through next year, when unemployment is around 7 percent, as long as the economy improves as expected.

He also sketched out the Fed's expectations for keeping rates low in the years ahead and for the even longer-term plan for shrinking the central bank's $3.4 trillion balance sheet.

"Well, that's three different parts of forward guidance," said Peter Fisher, senior director of the BlackRock Investment Institute. "I've been in this business a long time, and bond market guys aren't that clever. We can't price all that in."

As reported by Reuters.

I did, however, think it wise of Chairman Bernanke to clarify the Committee’s expectations regarding how the pace of asset purchases is likely to evolve. Bond and stock markets fell sharply in response, but that should not be too surprising. The Chairman’s statement forced financial market participants to re-evaluate the likely total amount of securities the Fed would buy under this open-ended purchase plan — in other words, how much liquor would ultimately be poured into the punch bowl. Market participants also had to reconsider their estimate of when the Federal Reserve would begin to remove the punch bowl by raising interest rates. These reassessments appear to have warranted price changes across an array of financial assets. As market participants gain additional insight from the words of Federal Reserve officials or by policy actions in coming quarters, further asset price volatility seems likely.

However, a key point is that as we approach an FOMC meeting where an adjustment decision looms, it is appropriate to give relatively heavy weight to the accumulated stock of progress toward our labor market objective and to not be excessively sensitive to the sort of near-term momentum captured by, for example, the last payroll number that comes in just before the meeting.

In part, this principle just reflects sound statistical inference--one doesn't want to put too much weight on one or two noisy observations. But there is more to it than that. Not only do FOMC actions shape market expectations, but the converse is true as well: Market expectations influence FOMC actions. It is difficult for the Committee to take an action at any meeting that is wholly unanticipated because we don't want to create undue market volatility. However, when there is a two-way feedback between financial conditions and FOMC actions, an initial perception that noisy recent data play a central role in the policy process can become somewhat self-fulfilling and can itself be the cause of extraneous volatility in asset prices.

Thus both in an effort to make reliable judgments about the state of the economy, as well as to reduce the possibility of an undesirable feedback loop, the best approach is for the Committee to be clear that in making a decision in, say, September, it will give primary weight to the large stock of news that has accumulated since the inception of the program and will not be unduly influenced by whatever data releases arrive in the few weeks before the meeting--as salient as these releases may appear to be to market participants. I should emphasize that this would not mean abandoning the premise that the program as a whole should be both data-dependent and forward looking. Even if a data release from early September does not exert a strong influence on the decision to make an adjustment at the September meeting, that release will remain relevant for future decisions. If the news is bad, and it is confirmed by further bad news in October and November, this would suggest that the 7 percent unemployment goal is likely to be further away, and the remainder of the program would be extended accordingly.

So, first of all, since it is a threshold and not a trigger, we are entirely free to take all of that into account before we -- before we begin the process of raising rates, and that's what the diagram suggests. People are saying that unemployment will be at 6.5 percent in late 2014 or early 2015, but they're saying that increases in rates may not follow, but several quarters after that.

In terms of adjusting the threshold, I think that's something that might happen. If it did happen, it would be to lower it, I'm sure, not to raise it.

[O]ur target is not 7, it’s not 6½, our target is maximum employment, which, according to our projections, most people on the Committee think is somewhere between 5 and 6 percent unemployment, and that’s where we’re trying to get to. The 7, the 6½—these are guideposts that tell you how we’re going to be shifting the mix of our tools as we try to land this ship on a, you know, on a—in a smooth way onto the aircraft carrier.

However, our policy approach was far from perfect. Comparing actual growth to the growth projections by FOMC participants in the Summary of Economic Projections shows that we were consistently too optimistic about growth over the 2009-2012 period. As a result, with the benefit of hindsight, we did not provide enough stimulus...

Also, we could have done better in communicating our intentions and goals. We put too much emphasis, too early, on the exit. At an earlier stage, we should have put greater emphasis on our commitment to use all our tools to the fullest extent possible for as long as needed to achieve our dual mandate objectives.

Our policies also had a “start-stop” aspect to them that may have undercut their effectiveness. For example, until September 2012, our large-scale asset programs generally specified the total size of the program, with a purchase rate and an expected ending date. This created a void when the programs ended and made our policy response sporadic and hard to forecast. This limited the scope for market prices to adjust in anticipation of our future actions in ways that would help stabilize the economy.

Another shortcoming was in our use of forward guidance with respect to the path of short-term interest rates. Although calendar-based guidance worked reasonably well in influencing expectations about the future path of short-term rates and thus the shape of the yield curve, it was clumsy in a number of respects. For example, if we moved the forward date guidance out in time, did this reflect a change in our reaction function, the amount of desired policy stimulus or greater pessimism about the outlook?

Of course, as we have learned, we have acted to rectify these shortcomings. For example, our asset purchases are now outcome based, tied to the goal of substantial improvement in the labor market outlook, and our forward guidance on short-term rates is tied to unemployment and inflation thresholds rather than to a calendar date.

[T]he Committee’s policy statements have specified that we expect to keep the federal funds rate exceptionally low at least as long as, one, “the unemployment rate remains above 6½ percent”; two, “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 three, longer-term inflation expectations remain in check.

With this forward guidance in place, members of the public can adjust their expectations for future Fed policy as new information on the economy becomes available. They don’t need to wait for the Fed to issue a new statement. For example, a slowdown in economic growth might cause the public to think that the prospect of reaching a 6½ percent unemployment rate was falling further back in time. They would then expect the Fed to wait longer to raise the federal funds rate, which would prompt them to push long-term interest rates down. And those lower long-term rates would help us achieve our monetary policy goals.

By lowering private-sector expectations of the future path of short-term rates, this guidance can reduce longer-term interest rates and also raise asset prices, in turn, stimulating aggregate demand. Absent such forward guidance, the public might expect the federal funds rate to follow a path suggested by past FOMC behavior in "normal times"--for example, the behavior captured by John Taylor's famous Taylor rule. I am persuaded, however, by the arguments laid out by our panelist Michael Woodford and others suggesting that the policy rate should, under present conditions, be held "lower for longer" than conventional policy rules imply.