Fed Faces Tough Sell on Low-Rate Strategy

September 16, 2013, 2:21 p.m. ET

Fed Faces Tough Sell on Low-Rate Strategy

Steadying Economy Poses Test on Key Easy-Money Policy

JON HILSENRATH

Federal Reserve officials face a communication challenge explaining their interest-rate plans when they gather for a policy meeting this week. Their updated economic projections could show an economy that appears back to normal by 2016, but their projections of where short-term interest rates will be could show rates still quite low by then. Their challenge: How to justify the low interest-rate plan when their own estimates suggest an economy regaining its health.The dilemma has been overlooked in recent weeks by investors and other observers more focused on other Fed dramas. One is the uncertainty about whom President Barack Obama will nominate to succeed Ben Bernanke as Fed chairman, particularly after the withdrawal from the race Sunday byLawrence Summers—a former economic adviser to the president who was a leading contender for the job.

The other issue is whether Fed officials will decide at their meeting Tuesday and Wednesday to start winding down their $85 billion-a-month bond-buying program. Fed officials face a close call at the meeting on whether to start pulling back on the bond-buying program, also known as quantitative easing, according to interviews with officials earlier this month and their public comments.

But the commitment to low rates is widely held inside the Fed, and officials have been searching for ways to reinforce their pledge. “Monetary policy will continue to be extraordinarily stimulative for quite some time,” San Francisco Fed President John Williams said in a speech earlier this month.

As the economy improves, the Fed is trying to shift its emphasis from bond buying, which has uncertain costs and benefits, to the low-rate pledge. Both the commitment to keep short-term rates low and the bond-buying program are meant to stimulate higher risk tolerance in financial markets and encourage borrowing, spending, investing and economic growth.

The Fed has pinned short-term rates near zero since December 2008 to help the struggling U.S. economy recover from deep recession. It has pledged to keep them near zero until the jobless rate drops to 6.5% or lower, a threshold Fed officials expect to cross by 2015. Still, officials have been vague in describing what they’ll do with rates once they do start raising them.

The Fed’s guidance on future short-term interest rates has a substantial influence on where markets move today’s long-term interest rates, such as those for mortgages, car loans and business borrowing. If investors doubt the Fed’s low-rate pledges, they could push up longer-term rates, raising borrowing costs for businesses and households and potentially restraining an already-sluggish recovery.

Explaining the path of rates far in the future will get more complicated when the Fed releases its 2016 forecasts for the first time on Wednesday. Those forecasts are likely to show an unemployment rate within the 5.2% to 6% range that officials believe is normal in the long run and an inflation rate near the Fed’s 2% target. The Fed’s most recent public forecast, made in June, showed the jobless rate right around 6% by the fourth quarter of 2015 and inflation near 2%.

Contrast the economic forecast with the Fed’s interest-rate forecasts. In the long run, Fed officials believe the federal funds rate—an overnight bank lending rate that they manage—should be around 4%. They consider that to be a “neutral” in the long run, a rate that leads neither to too much inflation nor too little.

But the latest official projections show Fed officials expect the federal funds rate to be about 1% by the end of 2015, rising by a small amount after the jobless rate dips below 6.5%. It looks unlikely that the Fed would aim for 4% by 2016. Mr. Bernanke has signaled that once the Fed starts raising rates, officials expect to proceed slowly.

How will the Fed square an economy near full employment with a federal funds rate that remains historically low?

“There is an inconsistency there,” said John Taylor, a Stanford University professor who has been critical of the Fed’s recent policies. He said it sounds like a formula for inflation or asset bubbles because monetary policy might be looser than the economy warrants.

Fed officials have hinted at several explanations for their interest-rate road map.

Janet Yellen, the Fed’s vice chairwoman and a contender to become next Fed chief, in two 2012 speeches pointed to computer models that work something like flight simulators. They spit out estimates for the federal funds rate that best produces low unemployment and stable inflation based on estimates of how the economy normally behaves. These “optimal control” models have pointed to the benefits of a low fed funds rate far into the future even as unemployment declines.

Some academic theories support this view. Columbia University’s Michael Woodfordhas argued for years that when the economy is hit by a shock and interest rates fall all the way to zero—as happened in 2008—the best way to recharge the economy is to promise to keep rates near zero even after the economy looks like its back on a normal footing.

Still, academic theory and arcane models are hard to sell to an often-skeptical public and perplexed investors.

A simpler explanation is also circulating around the Fed: Even if unemployment falls below 6% by 2016, the economy it will still be debilitated by the lingering effects of the 2008 and 2009 financial crisis and in continued need of a low interest rates to spur activity.

Put another way, a normal fed funds rate might be 4%, but the economy still won’t really be back to normal by 2016 so it will require the continued support of interest rates below that level. Because the economy will still face drags, this thinking goes, low rates won’t spark inflation.

They could take other steps to reinforce the low-rate pledge, such as assuring that rates won’t begin to rise if inflation is much below the Fed’s 2% target.

The Fed’s sales pitch could have a big impact on markets. Long-term rates on instruments such as mortgages and 10-year government bonds have already jumped by more than a percentage point since May, in part because of investor doubts about the central bank’s interest-rate plan.

The challenge is made harder by impending leadership changes at the Fed. Mr. Bernanke’s term as chairman ends in January and nobody knows the strategy of an as-yet unnamed successor.

Mr. Bernanke could be pressed on these issues at his press conference Wednesday, after the Fed meeting.

“He’s going to have to bob and weave around the question when it’s asked,” said Michael Feroli, economist with J.P. Morgan.