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U.S. Federal Reserve chairman Ben Bernanke smiles during a news conference in Washington on Wednesday.

KEVIN LAMARQUE/REUTERS

The U.S. Federal Reserve is taking the historic step of tying interest rates to joblessness as it puts its sights squarely – and publicly – on America's stubbornly high unemployment rate.

At the end of a two-day meeting in Washington on Wednesday, the Fed's policy committee surprised Wall Street by dropping a conditional pledge to leave its benchmark interest rate near zero until at least 2015, and replacing that commitment with even more explicit guidance. For decades, controlling inflation has been the primary focus for the Fed. But faced with the possibility of years more of stagnant job creation, Fed chairman Ben Bernanke is making public and explicit commitments to use interest rates to drive down unemployment.

Now, the Fed will base its eventual transition to a more normal policy setting when the jobless rate drops to 6.5 per cent, so long as the one-to-two-year outlook for inflation stays within a half percentage point of the central bank's 2 per cent target.

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Mr. Bernanke stressed at a press conference that the adoption of numeric thresholds marks a change in communications, and not a shift in the Fed's belief that extraordinary stimulus will remain the norm for several years.

The policy committee's revised economic outlook predicts the U.S. unemployment rate still will be above 6.8 per cent at the end of 2014, and 13 of 19 committee members said the benchmark rate should be left at its current setting near zero until 2015. A 14th member said rates shouldn't move higher until 2016.

With the unemployment rate at 7.7 per cent, Mr. Bernanke and the Fed are showing they are fully committed to doing their part to restore vibrancy to an economy that employs some four million fewer people than it did in 2007. The Fed also said Wednesday that it will continue buying financial assets at a pace of $85-billion (U.S.) a month until it is satisfied the labour market has improved "substantially."

By adopting numeric thresholds, the Fed is embracing the theory that the longer interest rates stay low, the more necessary it is to become transparent about when they could rise. That's important because if households, executives and investors doubt a central bank's nerve to keep borrowing costs low, they could balk at taking out new loans, and thus defeat the purpose of the policy.

"This is as aggressive as Fed easing has ever been," said Sherry Cooper, chief economist at Bank of Montreal, adding that the U.S. central bank is "clearly very concerned about the states of the U.S. economy."

The Fed's plan to keep stimulating the economy at least until unemployment has reached 6.5 per cent is intended to reassure consumers, companies and investors about the health of the economy, said Joseph Gagnon, a former Fed official who is a senior fellow at the Peterson Institute for International Economics.

Having only a target date of mid-2015 for any increase in interest rates "sounded gloomy," as if the economy would remain weak until then, Mr. Gagnon said. Specifying an unemployment rate – one close to a normal rate of 6 per cent or less – makes clear that the Fed will keep supporting the economy even after the job market has strengthened significantly. "This is trying to get away from that sense of `Oh, my God, this is all about gloom and doom.' "

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Mr. Bernanke said it would be a mistake to assume the Fed now is on "auto-pilot," telling reporters that he and his colleagues will be vigilant in tweaking policy to match economic conditions. If inflation gets uncomfortably hot before the unemployment rate drops to 6.5 per cent, the Fed likely would raise interest rates. However, the Fed doesn't see that as likely, predicting inflation will advance no faster than 2 per cent through 2015.

The Fed's enhanced transparency will attract criticism from those who argue that the pledge to leave interest rates low for increasingly longer periods will stoke runaway inflation. Richmond Fed president Jeffrey Lacker voted against the Fed's new policy, while the eleven other voting members of the policy committee endorsed the move.

Typically, central banks are careful not to give away too much information in order to avoid unduly influencing financial markets. But in the aftermath of the financial crisis, policy makers are coming around to the notion that a clear path for interest rates is necessary to bolster confidence.

"Today, to achieve a better path for the economy over time, a central bank may need to commit credibly to maintaining highly accommodative policy even after the economy and, potentially, inflation picks up," Bank of Canada Governor Mark Carney said in a speech in Toronto on Tuesday. "Market participants may doubt the willingness of an inflation-targeting central bank to respect this commitment if inflation goes temporarily above target. These doubts reduce the effective stimulus of the commitment and delay the recovery."

The Fed is testing the faith of the public with its aggressive bond buying, an untested monetary strategy known as quantitative easing. The central bank said Wednesday that it would continue buying $40-billion a month of financial assets backed by home loans, and would purchase Treasuries that mature in four to 30 years at a pace of $45-billion a month. All the buying will be done with newly created money, which some economists say will cause inflation and asset-price bubbles.

Mr. Bernanke said he is cognizant of the risks, and that the Fed will proceed carefully, indicating that he would purchase financial assets at an even faster rate if he wasn't so worried about the risks of doing so.

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"If we could wave a magic wand and get the unemployment rate down to 5 per cent we'd do that," Mr. Bernanke said.

With files from Associated Press

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