In a new AEI Economic Perspectives paper, titled “Isn’t It Ironic? The Outlook for Federal Reserve Policy,” visiting scholar Vincent Reinhart sketches the state of the US economy, and then proceeds to analyze the tactical and strategic imperatives currently guiding Federal Reserve policymaking.
He first points out that while the headline unemployment rate has fallen rapidly over the past few years, more indirect measures suggest that more resource slack remains than the current 5% rate would at first blush suggest.
Federal Reserve Chairman Janet Yellen speaks at an event hosted by the Economic Club of Washington in Washington December 2, 2015. REUTERS/Joshua Roberts.
Some of this – the relatively slow pace of the recovery – is a product of slowing population and productivity growth, while wage, compensation, and inflation numbers suggest that caution in tightening monetary conditions is indeed still called for.
This combination of factors produces the following dilemma for Federal Reserve Chair Janet Yellen and her allies. On the one hand, they need to assuage the concerns of inflation hawks. On the other hand, they would like to maintain an accommodative stance for as long as possible.
In addition, they need to end up with a planned course of action that is credible to market participants. Mr. Reinhart walks us through these various considerations, and concludes that by raising rates sooner rather than later, Yellen et al. buy themselves the opportunity to follow up on that first increase with a relatively shallow subsequent path. The big challenge that remains is to provide guidance to the effect that this first rate hike does not foreshadow rapid subsequent hikes.
What the Fed will want to avoid doing is triggering a rapid tightening of financial conditions at a time when economic performance, even more so overseas than domestically, is still nowhere near boom and bonanza territory.
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