Is this a promise, maybe? That's how most people interpreted it, but it's not entirely clear. Read it again. The Fed was saying it expected the economy to be crummy enough to justify zero rates until mid-2015. But what if the economy picked up before then? Would the Fed raise rates then? Good question! The Evans Rule clears this up a bit (although not entirely), but more importantly, it clears up whether the Fed has a 2 percent inflation target or ceiling.
The Fed has been trying to answer that question for the past year. As Greg Ip of The Economist pointed out, the Fed rather significantly announced back in January that it thought the inflation and unemployment halves of its mandate were equally important, and changed its long-run inflation target from 1.5 percent to 2 percent. This was the Fed's way of saying it wouldn't necessarily raise rates if inflation crept over 2 percent as long as unemployment was still high and long-run inflation expectations didn't rise. In other words, the Fed's inflation target was not a 2 percent speed limit on the recovery. Or was it? Look at that table again. The Fed doesn't project inflation to go above 2 percent at all. That sure looks like a ceiling, still. The Evans Rule tries to correct this, although it would help if these latest projections were symmetrical around 2 percent, by explicitly saying the Fed really, seriously will tolerate inflation as high as 2.5 percent in the short run.
But there's plenty that still isn't clear. Like how and whether this will work. The Evans Rule sounds straightforward enough, but these thresholds are not. The Fed left itself a bit of wiggle room. When it comes to unemployment, the Fed will look at other labor-force measures like the participation rate. In other words, it will consider whether unemployment is falling because people are finding jobs or because people have given up on finding jobs. It gets murkier when it comes to inflation. The Fed will use its one- to two-year inflation forecasts for its threshold. Yes, forecasts. That gives the Fed some needed flexibility to ignore commodity surges, like oil in 2011, but it's not the clearest of guides.
Remember, clarity is supposed to be the point. The idea is that the more markets understand the Fed's plans, the more the Fed's plans will shape markets' expectations. It's a bit like a Jedi mind trick. If people think things will be better in the future, then things will be better in the future, because that will get them spending and investing more now. Making us expect a better tomorrow might be the best the Fed can do today. Especially when you consider how short-lived the effects have been from the Fed's other unconventional easing. You can see that in the chart below that looks at market-based inflation expectations for one-, two-, and 10-year periods. Inflation expectations rise every time the Fed does something, and then retreat a few months later.
(Note: These break-evens measure the differences between Treasury and TIPS, or inflation-protected, bonds. They aren't always reliable because TIPS are so lightly traded--their nickname is "terribly illiquid pieces of ----," well, we'll let you figure out the rest--but they're a decent proxy. All data is from Bloomberg.)
Inflation expectations should tick up again, especially if we disarm the austerity bomb known as the fiscal cliff, but the overall pattern of peaks and valleys probably isn't going to go away yet.
The Fed's other (slightly less) big announcement was that it will continue its $85 billion of monthly asset purchases, albeit with a slight, um, twist. Here's what hasn't changed: The Fed will buy $45 billion of Treasury bonds and $40 billion of mortgage bonds each and every month until unemployment "substantially" improves. What has changed is how the Fed will pay for its $45 billion of Treasury bond purchases. Before, the Fed had been selling $45 billion of short-term bonds to pay for the $45 billion of long-term bonds it was buying, which went by the dramatic name of "Operation Twist." It was a way to lower long-term borrowing costs without printing money, back when more Fed members were worried about potential inflation. But with its supply of short-term Treasuries running, well, short, the Fed will turn Twist into QE. In other words, it will now print money to pay for the $45 billion of Treasuries it buys. The Fed's balance sheet will grow more than before, although its monthly flow of purchases remains the same.