Will the Fed Ditch the Evans Rule?

A little over a year ago, the Federal Reserve introduced a new policy: The Fed said it wouldn’t raise short-term interest rates until the unemployment rate reached 6.5%. Ben Bernanke was careful to say that this was a threshold and not a trigger. He’s repeated that many times since.

The use of this specific economic metric has been referred to as the Evans Rule in honor of Chicago Fed President Charles Evans, who has advocating using such a strategy. One of the odd parts of monetary policy is that it’s much more effective if it’s seen as credible. A central bank can yammer all they want, but if no one believes them, the implementation of policy becomes that much harder. Credibility is the watchword for any modern central banker.

While the Fed is still seen as an opaque and secretive institution, Ben Bernanke has probably pulled back the curtain more than any other Fed chair. As such, the Bernanke Fed has also been careful in telegraphing their intentions to market participants (see Hilsenrath comma Jon). That’s also why last year’s Taper Tantrum was so bizarre.

I think the commitment to credibility is why the Evans Rule may not live much longer, or more specifically, the 6.5% threshold. The fact is that the unemployment rate is falling, and falling rather quickly. The rate for November was 7.0%. This morning’s ADP report was encouraging, and now it seems very likely that we could hit 6.5% unemployment by the middle of this year. The report for December comes out this Friday.

Yet there seems to be no demand for short-term interest rates to rise anytime soon. The one-year Treasury is still around 0.13%. At this point, most FOMC members don’t expect a Fed rate increase until 2015—and a good majority of them don’t expect much of an increase next year.

Will it hurt the Fed’s vaunted credibility with the market as unemployment drops and the Fed does nothing month after month? You could say that Bernanke’s threshold-not-trigger statement grants them some leeway, but how much? When the Fed adopted the Evans Rule in December 2012, it was a cost-free commitment. The rule told traders what to expect and when, and helped remove a lot of worry from the markets. But now that promise is coming due.

I rate this as an event with a low probability but one with a large potential impact. At some point this year, the Fed may alter the Evans Rule and lower the threshold to 6%.

One final note: Here’s a very simplified version of the Taylor Rule, with variables via Paul Krugman (the Fed Funds rate should be 1.8 times the difference between unemployment and inflation, plus 9). Please note that Krugman has said that “using historical estimates of the Taylor rule is not a good way either to predict Fed policy or to recommend Fed policy at this point in our history.” It’s a better estimate to what the Fed has been thinking.

Posted by Eddy Elfenbein on January 8th, 2014 at 9:23 am

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