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The leaders of the Federal Reserve just did something that sounds boring but is actually a big deal: They promised to keep short-term interest rates at zero at least until the unemployment rate falls below 6.5 percent, or inflation rises to over 2.5 percent.
It's clear on its face why this sounds boring. It takes a little doing to explain why it's a big deal.
First, picture Ben Bernanke with his hair on fire — an image invoked by Charles Evans, the president of the Chicago Fed.
In a big speech last year, Evans reminded his audience that the Fed is supposed to keep both inflation and unemployment low. But for several years now, inflation has been quite low and unemployment has been quite high. What if the reverse were true? Evans said:
Imagine that inflation was running at 5 percent against our inflation objective of 2 percent. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn't any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.
In other words, if inflation were really high, central bankers would be totally freaked out and doing everything they could think of to bring it down. Central bankers should be equally freaked out about the high unemployment rate, Evans argued.
What, in particular should the Fed do? Basically, Evans said, the Fed should use its words.
When the Fed is worried about unemployment, it lowers interest rates to encourage businesses to borrow money to build new buildings and hire new workers.
But the main interest rate controlled by the Fed — a very short-term rate — hit zero in 2008. That meant that the Fed's conventional tool was spent.
Still, the Fed can have incredible influence simply by explaining its long-term plans. If it not only lowers short-term interest rates, but also promises to keep them low for a long time, lenders will respond by lowering long-term rates. Those are what really matter for people and businesses borrowing money to make investments.
The Fed had already promised to keep rates low for a couple years. But it should go further, Evans argued. The Fed should promise that, unless inflation starts to rise, short-term interest rates will remain at zero until the unemployment rate comes way down.
The language Evans proposed — the language the Fed adopted in its statement today — sends a clear signal to businesses considering borrowing money to make investments: Do it. Interest rates will probably be super low until the economy gets better.
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