Minneapolis Fed President Narayana Kocherlakota has been urging his colleagues to adopt a lower unemployment threshold, to 5.5 percent. Evans today said his thinking is “not largely inconsistent with President Kocherlakota’s proposal” because, if inflation remained low, he would support keeping rates near zero even after joblessness fell below 6.5 percent.

“Unemployment might get down to 6 before we see the need” to tighten, he said. “If the committee viewed it as additionally useful to adjust that threshold” down, “I would certainly pay attention to that. I don’t anticipate I would have a problem with that.”

While some commentators have speculated that the Fed may set a lower bound on inflation, “I don’t really appreciate how that helps in providing the appropriate amount of accommodation,” he said.

I emphasize that, because our asset purchases depend on economic and financial developments, they are by no means on a preset course. On the one hand, if economic conditions were to improve faster than expected, and inflation appeared to be rising decisively back toward our objective, the pace of asset purchases could be reduced somewhat more quickly. On the other hand, if the outlook for employment were to become relatively less favorable, if inflation did not appear to be moving back toward 2 percent, or if financial conditions--which have tightened recently--were judged to be insufficiently accommodative to allow us to attain our mandated objectives, the current pace of purchases could be maintained for longer. Indeed, if needed, the Committee would be prepared to employ all of its tools, including an increase the pace of purchases for a time, to promote a return to maximum employment in a context of price stability.

…

As I have observed on several occasions, the phrase "at least as long as" is a key component of the policy rate guidance. These words indicate that the specific numbers for unemployment and inflation in the guidance are thresholds, not triggers.. For example, if a substantial part of the reductions in measured unemployment were judged to reflect cyclical declines in labor force participation rather than gains in employment, the Committee would be unlikely to view a decline in unemployment to 6-1/2 percent as a sufficient reason to raise its target for the federal funds rate. Likewise, the Committee would be unlikely to raise the funds rate if inflation remained persistently below our longer-run objective. Moreover, so long as the economy remains short of maximum employment, inflation remains near our longer-run objective, and inflation expectations remain well anchored, increases in the target for the federal funds rate, once they begin, are likely to be gradual.

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.

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.

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.

[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.

In its current forward guidance, the FOMC has stated that it expects the fed funds rate to remain extraordinarily low at least until the unemployment rate falls below 6.5 percent. The FOMC could provide additional needed stimulus by lowering the threshold unemployment rate from 6.5 percent to 5.5 percent—that is, by changing one number in the existing statement.

To see why I say so, consider two possible scenarios. In the first, the public believes that the FOMC will begin raising the fed funds rate once the unemployment rate hits 6.5 percent. (To be clear: This belief is consistent with, but not necessarily implied by, the FOMC’s current forward guidance.) In the second, the public believes that the FOMC will defer the initial increase in the fed funds rate until the unemployment rate hits 5.5 percent. The higher unemployment rate in the first scenario means that monetary policy will be tightened sooner, which, in turn, will lead to the unemployment rate being higher for longer. Foreseeing that, people will save more in the first scenario than in the second, to protect themselves against these higher unemployment risks. Because they save more, they spend less, and there is less economic activity.

Thus, lowering the unemployment rate threshold to 5.5 percent would increase the demand for goods and thereby push upward on both employment and prices. Would this extra monetary stimulus result in an undue amount of inflation at some point in the future? ... To me, this historical evidence suggests that, as long as the unemployment rate remains above 5.5 percent, the medium-term inflation outlook will stay close to 2 percent.

If quantitative thresholds are good for interest rate guidance, why not also have such thresholds for the asset purchase program? There are two reasons. There is somewhat more uncertainty about the efficacy and costs associated with asset purchases than rate guidance and we are likely to learn more about the efficacy and costs as the program unfolds.

So what is this likely to mean in practice? In my view, we should calibrate the total amount of purchases to that needed to deliver a substantial improvement in labor market conditions, by allowing the flow rate of purchases to respond to material changes in the labor market outlook. This makes sense because the benefits of additional accommodation will gradually diminish as we get closer to our full employment and price stability objectives and become more confident that we will reach them in a timely manner. At some point, I expect that I will see sufficient evidence of economic momentum to cause me to favor gradually dialing back the pace of asset purchases.

Of course, any subsequent bad news could lead me to favor dialing them back up again.

The lack of thresholds [for the Fed’s open-ended asset purchases] comes from the complexity of the problem. On the one hand, we have benefits which are associated with improvements in the economy, but there are also costs associated with unconventional policy, such as the potential effects on financial stability, which are hard to quantify and which people have different views about.

So to this point, we've not been able to give quantitative thresholds for the asset purchases in the same way that we have for the federal funds rate target. We're going to continue to try to provide information as we go forward.

In particular, as I mentioned today, as we make progress towards our objective, we may adjust the flow rate of purchases month to month to appropriately calibrate the amount of accommodation we're providing, given the outlook for the labor market.

In terms of further color, again, given the complexity of the issue, we've not given quantitative analysis or quantitative thresholds. I would say that we'll be looking for sustained improvement in a range of key labor market indicators, including, obviously, payrolls, unemployment rate, but also others, like the hiring rate, claims for unemployment insurance, quit rates, wage rates, and so on, be looking for sustained improvement across a range of indicators and in a way that's taking place throughout the economy.

And since we're looking at the outlook, we're looking at the prospects rather than the current state of the labor market, we'll also be looking at things like growth to try to understand whether there's sufficient momentum in the economy to provide demand for labor going forwards. So that will allow to us look through, perhaps, some temporary fluctuations associated with short-term shocks or problems.

In my view, the language now incorporated into the statement affirmatively conveys the Committee's determination to keep monetary policy highly accommodative until well into the recovery. And the specific numbers that were selected as thresholds for a possible change in the federal funds rate target should confirm that the FOMC expects to hold that target lower for longer than would be typical during a normal economic recovery...

I view the Committee's current rate guidance as embodying exactly such a "lower for longer" commitment. In normal times, the FOMC would be expected to tighten monetary policy before unemployment fell as low as 6-1/2 percent. Under the new thresholds guidance, the public is informed that tightening is unlikely as long as unemployment remains above 6-1/2 percent and inflation one to two years out is projected to be no more than a half percentage point above the FOMC's 2 percent longer-run goal.

The liftoff plan is to sustain low interest rates—that is, we’ll keep the fed funds rate extraordinarily low—at least until unemployment falls below 5 1/2 percent, as long as the medium-term outlook for inflation remains within a quarter of a percentage point of 2 percent, the long-run target. “Medium term” meaning—I’m very precise on this in the speech—but it basically means a two-years-ahead outlook for inflation.

…

I set {the inflation threshold} at a quarter percentage point because, actually, given how high unemployment is, I think it’s unlikely we could ever get the medium-term inflation outlook to be as high as 2 1/4 percent, frankly.

…

Given the Committee’s thinking, typically, about how it views its longer-run objectives, the 2 1/4 percent/5 1/2 percent numbers were consistent with how I thought the Committee would behave in the future, basically. And you don’t want to lay out something that seems implausible for the Committee to deliver on.