U.S. Monetary Policy: Avoiding Dark Corners

IMF Blog, June 25, 2015

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The Fund suggested the Federal Reserve could defer its first increase in the policy rate until it sees greater signs of wage or price inflation, followed by a gradual increase in the federal funds rate thereafter.
The Fed has argued it is likely to start in the second half of this year, contingent on the state of the U.S. economy; Chair Janet Yellen used the word “gradual” several times and FOMC members forecast an unhurried pace of policy rate increases.
Preliminary findings of the ongoing IMF health check of the U.S. economy:
- Despite a weak first quarter, growth in the coming months is likely to pick up.
- Growth is expected to be accompanied by steady gains in job creation.
A data-dependent approach calls for a gradual pace of monetary policy normalization.
The IMF mission argued the first step along that gradual path should happen once there are more tangible signs of wage or price inflation than are currently evident.

Monetary policy must weigh multiple two-sided but uncertain risks; the paper provides a framework for this assessment.
Under conditions of still recovering demand, low inflation, and the policy interest rate near zero, the balance of risks favors more patience before starting interest rate increases.
Consequences of waiting to start increases:
- Subsequent rate increases would still be gradual, albeit on a slightly steeper path.
- A modest planned overshooting of inflation may occur temporarily.
Rationale and intuition:
- It is costly to have the policy interest rate at zero, where the room for maneuver to respond to negative shocks becomes constrained—the “dark corner.”
- Given potential future negative shocks that could push the economy back toward low growth and falling inflation, optimal policy should aim to return the economy to full employment and away from the dark corner as quickly as possible.
- Waiting longer to begin rate increases—described as waiting until the “whites of inflation’s eyes are visible”—provides insurance against returning to zero interest rates.
- The case for patience is strengthened by uncertainties related to the amount of slack and the neutral policy rate.
Trade-off:
- Such a policy can temporarily generate a bit more inflation, which the authors regard as a reasonable cost given well-anchored expectations and the Fed’s credibility in addressing inflation.

The authors argue for strengthening the Fed’s communication strategy to help avoid dark corners; effective public understanding of the Fed’s future actions is critical.
Flexible inflation targeting, as practiced by several central banks, provides a useful template emphasizing numerical inflation objectives and stronger communication practices.
Proposed enhancement: the Fed could start publishing a regular monetary policy report that:
- Contains forecasts for key economic indicators—inflation, output, and interest rates.
- Presents alternative scenarios to illustrate uncertainties around the outlook.
Benefits of a regular, consistent macroeconomic forecast report:
- Provides a clearer picture of the “gradual” path emphasized by Chair Yellen, focusing attention on the whole path of rate increases rather than the specific date of the initial increase.
- Highlights that the full path of rate increases matters most for the economic outlook.
Implementation considerations:
- Logistical challenges include forging agreement on a path for policy rates within a large and diverse Federal Open Market Committee.
- These challenges should be outweighed by the exceptional value of a fully articulated and internally consistent forecast, published regularly and endorsed by the FOMC.

U.S. Monetary Policy: Avoiding Dark Corners — June 25, 2015.