Fed Should Be Wary of Moving too Gradually

Inflation uncertainty supports gradual hikes in the federal funds rate, Fed Chair Yellen said in a speech at the NABE meeting, suggesting another rate hike this year is still on the table. Chair Yellen also added that the outlook is uncertain and some key assumptions underlying employment and inflation could be wrong. Thus, a revised assessment could lead to an easier policy path.

Excerpts from Chair Yellen Speech at the 59th Annual Meeting of the National Association for Business Economics, Cleveland, Ohio:

A more important issue from a policy standpoint is that some key assumptions underlying the baseline outlook could be wrong in ways that imply that inflation will remain low for longer than currently projected

What are the policy implications of these uncertainties? For one, my colleagues and I must be ready to adjust our assessments of economic conditions and the outlook when new data warrant it. In this spirit, FOMC participants--like private forecasters--have reduced their estimates of the sustainable unemployment rate appreciably over the past few years in response to the continual flow of information about the always changing economy. To the extent these assessments change over time, so too will the outlook and judgments about the appropriate stance of monetary policy. Importantly, even if resource utilization is currently lower than we estimate or if longer-run inflation expectations are running at levels consistent with longer-run PCE price inflation somewhat below 2 percent, the FOMC can still achieve its inflation goal. Under those conditions, continuing to revise our assessments in response to incoming data would naturally result in a policy path that is somewhat easier than that now anticipated--an appropriate course correction that would reflect our commitment to maximum employment and price stability.

How should policy be formulated in the face of such significant uncertainties? In my view, it strengthens the case for a gradual pace of adjustments. Moving too quickly risks overadjusting policy to head off projected developments that may not come to pass. A gradual approach is particularly appropriate in light of subdued inflation and a low neutral real interest rate, which imply that the FOMC will have only limited scope to cut the federal funds rate should the economy be hit with an adverse shock. But we should also be wary of moving too gradually. Job gains continue to run well ahead of the longer-run pace we estimate would be sufficient, on average, to provide jobs for new entrants to the labor force. Thus, without further modest increases in the federal funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession. Persistently easy monetary policy might also eventually lead to increased leverage and other developments, with adverse implications for financial stability. 

To conclude, standard empirical analyses support the FOMC's outlook that, with gradual adjustments in monetary policy, inflation will stabilize at around the FOMC's 2 percent objective over the next few years, accompanied by some further strengthening in labor market conditions. But the outlook is uncertain, reflecting, among other things, the inherent imprecision in our estimates of labor utilization, inflation expectations, and other factors. As a result, we will need to carefully monitor the incoming data and, as warranted, adjust our assessments of the outlook and the appropriate stance of monetary policy. But in making these adjustments, our longer-run objectives will remain unchanged--to promote maximum employment and 2 percent inflation.

Fed Should Be Wary of Moving too Gradually

Federal Reserve | Joana Taborda | joana.taborda@tradingeconomics.com
9/26/2017 5:40:22 PM