Third time lucky. In each of the past two years, the Federal Reserve has predicted multiple interest-rate rises, only to be thrown off-course by events. On March 15 the central bank raised its benchmark Federal Funds rate for the third time since the financial crisis, to a range of between 0.75 percent and 1 percent. This was, if anything, ahead of its forecast, which it reaffirmed, that rates would rise three times in 2017.
“Lift-off” at last is an apt metaphor for monetary policy. However, as Fed chairwoman Janet Yellen picks up speed in terms of policy, she must navigate a cloudy political outlook. The next year will define her legacy.
Yellen took office in February 2014 after the Obama administration dithered over a choice between her and former Treasury Secretary Larry Summers. Today Yellen looks more hawkish—certainly more than Summers, who regularly urges the Fed to keep rates low. Headline inflation has risen to 1.9% a year, but, excluding volatile food and energy prices, it is a bit stuck, at around 1.7 percent.
Nonetheless, Yellen has not really changed her plumage. As expected, she has consistently given high weight to unemployment. Now that unemployment is only 4.7 percent, she is keener to raise rates than are those who worry about stubbornly low inflation.
In March 2015 Yellen argued that, were the Fed to ignore a tight labor market, inflation would eventually overshoot its 2-percent target. The Fed might then need to raise rates sharply to bring it back down, risking a recession—and, hence, more unemployment. Better to lift rates in advance.
Unemployment, however, was already down to 5.5 percent. Inflation remained strangely tepid, though, with cheap oil and a strong dollar partly to blame. Wages also seemed stuck, however, so Yellen and her colleagues deduced that unemployment could safely fall a bit further.
In the end they raised rates once in 2015, in December. Again they forecast four rate hikes for the next year. This time they were delayed by worries over the global economy, as China wobbled early in 2016. Officials also began to see lower rates as a permanent feature of the economy. Today the setters think that rates eventually will stabilize at 3 percent.
Yellen’s Fed, then, has proven willing to change course. This time the Fed is speeding up, rather than postponing, rate hikes.
Three factors are at play. First, the global economy has been reflating since the middle of 2016. Second, financial markets are booming, boosting the economy by almost as much as three interest-rate cuts, by some estimates. Third, a fiscal stimulus is looming. According to the Fed’s model, a tax cut worth 1 percent of GDP would push up interest rates by nearly half a percentage point. During his campaign Donald Trump promised cuts worth nearly 3 percent of GDP, according to the Tax Policy Center, a think tank.
In October Yellen wondered aloud whether a “high-pressure economy,” and a resulting wage boom, might coax more people to seek work. A gentle pickup in wage growth since mid-2015 seems to support her view that unemployment is the best measure of economic slack.
Rarely has unemployment been this low without inflation taking off. Once was in the late 1990s, when former Fed chairman Alan Greenspan correctly predicted that rising productivity would stop a booming labor market from stoking inflation.
That is what Yellen wants to avoid, but the Fed has not often managed to tighten monetary policy without an ensuing recession. Should she manage it, her tenure will go down as a great success.
Her term will end in February 2018. If Trump replaces her, she could stay on as a board member, but probably she would leave. So would Vice Chairman Stanley Fischer, whose term will expire four months later. Two of the Fed’s seven seats already are vacant, and Daniel Tarullo, the de-facto vice chairman for regulation, will leave in April. Thus Trump may be able to appoint five governors, including the chairman, within 18 months of taking office.
© 2017 Economist Newspaper Ltd., London (March 18). All rights reserved. Reprinted with permission.
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