The Fed's Puzzling Uncertainties

The Fed's new chair, Janet Yellen, faces a peculiarly uncertain outlook for the U.S. economy.
It's a peculiarly uncertain world for Janet Yellen. Photographer: Andrew Harrer/Bloomberg

Federal Reserve Chair Janet Yellen made a speechyesterday to the Economic Club of New York that will undoubtedly stimulate debate on what the world's most powerful central bank is thinking, doing and should be doing. It set out the country's economic challenges, clarifying her thinking on "three big questions" about slack in the labor market, the trajectory of inflation and possible threats to the recovery.

What also caught my attention, however, was the way Yellen addressed the uncertain outlook facing the U.S. economy and policy makers at the Fed.

The crucial sentence comes right at the start of her speech: "The path of the economy is uncertain, and effective policy must respond to significant unexpected twists and turns the economy may take." Yellen's words echo those of her predecessor, Ben Bernanke, who started referringto the "unusually uncertain" outlook back in 2010.

It is indisputable that the economy has been subjected to unusual and unanticipated shocks. Witness the congressional dysfunction that, on one occasion, almost led to a technical sovereign debt default and, on another, shut down the government for more than two weeks. Consider the way the Europeans initially dealt with their regional financial crisis. Then there is the geopolitical angle, including the Ukrainian crisis.

But I have the sense that, like Bernanke, Yellen could be referring to something broader.

In the last few years, the Fed has consistently overestimated growth and job creation. This forecasting error stems in part from historic global economic realignments, and in part from the impairment of mechanisms -- such as corporate investment and bank lending -- that have traditionally transmitted monetary policy to the economy. Given the number of variables in play in the aftermath of the 2008 global financial crisis, neither of these are amenable to confident comprehensive assessments by the Fed, or by anyone else for that matter.

A related, more systemic issue may also be at play. The Fed has had a hard time getting its arms around a rather unusual combination of cyclical, structural and secular headwinds to the U.S. economy; and to the extent that it tries, which it does very hard, the traditional cyclical bias can prove quite dominant.

The consequences of these headwinds, including their unusual internal interactions, are meaningful. They extend well beyond economics and finance to encompass political, social and inequality dimensions. And they operate on a daily basis through three meaningful channels: inadequate aggregate demand, insufficient productivity growth and lingering debt overhangs.

As of now, and despite heated debates, few agree fully on the weights to be given to these factors, both in aggregate and especially individually. Until this and other basic issues are resolved, along with their implications for policy, it won't just be the Fed that has to "systematically respond to unforeseen economic developments." Companies, individuals and governments will all be dealing with unusual "twists and turns."

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