Two heavyweight Fed papers argue for stronger policy action


By Alister Bull

WASHINGTON, Nov 5 (Reuters) - Two of the Federal Reserve'stop staff economists make the case in new research papers formore aggressive action by the U.S. central bank to drive downunemployment by promising to hold interest rates lower forlonger.

The papers provide valuable insight into the central bank'sthinking at a time when Fed Vice Chair Janet Yellen ismaintaining strict silence ahead of a Senate hearing on hernomination to succeed Chairman Ben Bernanke in January.

The studies were authored by teams led by William English,head of the Fed's monetary affairs division, and David Wilcox,the central bank's director of research and statistics. Theywill be presented at an International Monetary Fund conferencein Washington on Thursday and Friday, respectively.

The Fed has kept interest rates near zero since late 2008and has vowed to hold them there at least until the unemploymentrate hits 6.5 percent, provided the outlook for inflation doesnot rise above 2.5 percent. The U.S. jobless rate was 7.2percent in September.

"The studies suggest that some of the most senior Fedstaffers see strong arguments for a significantly greater amountof monetary stimulus," Goldman Sachs Chief Economist Jan Hatziuswrote in a research note to clients. His takeaway was that theFed would likely lower the unemployment threshold to 6.0 percentat its March meeting.

The paper co-authored by English studied what would happenif the Fed strengthened this so-called forward guidance.

It found that economic benefits were higher when theunemployment threshold was 6.0 percent, compared to 6.5 percent,and higher still if it was 5.5 percent compared to 6.0 percent.It did not find much evidence to support altering the inflationthreshold, as some have advocated.

The paper co-authored by Wilcox examined evidence that thecosts of high unemployment on the productive capacity of theU.S. economy were much larger than thought, strengthening theargument to allow inflation to overshoot the Fed's 2 percenttarget to bring the level of joblessness down faster.

Both papers discussed a so-called optimal policy path,echoing the findings Yellen herself laid out in a speech lastyear that urged policy forbearance if inflation temporarilyovershot the Fed's price stability objective.

Yellen can expect to be quizzed about this view at a SenateBanking Committee hearing that is likely to be held on Nov. 14.

Other economists were not so sure the Fed will lower itsunemployment threshold, since the English paper also discussedthe costs to the central bank's long-term credibility ofchanging the thresholds.

But they agreed that neither paper advocated heavily for theFed's bond-buying program, which has quadrupled the size of thecentral bank's balance sheet to $3.8 trillion in an effort tohold down long-term borrowing costs.

Officials have already said they would like to start scalingthe program back, but stunned markets in September when theyopted to keep buying bonds at an $85 billion monthly pace. Theymaintained that stance at a meeting last week.

The emphasis on the benefits of stronger forward guidance inthe paper by English and his two colleagues, however, suggestedthat officials may at least opt to give more clues about howthey would respond as the U.S. jobless rate nears their current6.5 percent threshold.

This could be done when Fed policymakers decide to beginreducing bond purchases to help offset any adverse marketreaction by showing a commitment to keep interest rates low.

Bernanke, whose term expires at the end of January, toldreporters in September that there were a number of ways in whichthe forward guidance could be strengthened.

"We could provide more information about what happens afterwe get to 6.5 percent and those sorts of things, and to theextent that we could provide precise guidance, I think thatwould be desirable," he said.

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