Timing of Fed Policy Choices by Nina Sheridan

The Fed must think in advance. It should not have the effects of its expansionary policy still being felt once the economy is fully recovered. In order to decide when the Fed should stop its bond purchases altogether, it should look at all of the different economic indicators, but particularly those that relate to unemployment and price stability.

If the unemployment rate remains the same or continue to decrease, and inflation is projected to remain stable, the Fed should end its purchases by continuing to taper at 10 billion a month, leading to an end of the program in the next seven months. Unemployment is at a five year low, but is projected to only fall to 6.3% by December according to Fed projections. This is above the long run unemployment rate, and with the labor force participation rate down 2.7% from five years ago, it would only be appropriate to end the taper earlier if the labor force participation rate rose to previous levels.

The next step the Fed must take in removing its accommodative policy is raising the Fed Funds rate. This cannot begin until the Quantitative Easing program has ended, because even with the taper, the Fed is still buying long-term securities, which is expansionary policy. After the Quantitative Easing program has ended, the Fed should look at the indicators to decide when to implement the contractionary policy of bringing the Fed Funds rate back to normal levels. The Fed should wait until inflation has risen back to the target 2%, real GDP growth is above 3%, and the unemployment rate has fallen to 6%, which is in the range for long run unemployment (5.2%-6% according to the Fed). Inflation is important to consider because raising the Fed Funds rate is a contractionary measure, and we do not want to risk a decrease in the inflation rate when it is already so low. If the expected inflation rate rises unexpectedly, the Fed should reconsider the timing, and it would likely be appropriate to begin to increase the Fed Funds rate earlier.

I think the Fed will begin to raise the Fed Funds rate towards the end of 2014 or the beginning of 2015. A recent Wall Street Journal survey shows economists predict that real GDP growth with be 3% in the third and fourth quarter of this year. It is highly likely that the QE program will have ended by this point. The CPI is projected to be 1.9% by December of 2014, very close to the Fed’s target. Unemployment is not predicted to be below 6%, but I think if the other indicators show good signs and unemployment continues to decrease, the Fed will start to incrementally raise the rate.