The Fed's Long Trip Back to Normal

The Fed must strike a delicate balance between an improving U.S. recovery and a worsening outlook abroad.

What a long, strange trip it will be.

Photographer: Daniel Acker/Bloomberg

The U.S. Federal Reserve is poised to take yet another step away from its extraordinary efforts to support the U.S. economic recovery. In doing so, it must strike a delicate balance between an improving recovery at home and a worsening outlook abroad.

Over the past several years, the Fed has relied on three main instruments to boost growth and generate jobs: extremely low interest rates, guidance on the probable future path of rates, and the bond-buying program known as quantitative easing. By lowering borrowing costs and pushing up the prices of stocks and bonds, the measures are supposed to encourage consumers to spend and companies to invest -- hopefully before the potential benefits are overwhelmed by adverse side effects such as excessive risk-taking in financial markets.

After many fits and starts, the economic recovery is finally rising to the Fed's expectations, allowing the central bank to start pulling back on stimulus. In October it stopped its program of quantitative easing. At its policy-making meeting this week, it will likely alter its forward guidance by removing a promise to keep interest rates floored near zero for a “considerable period" -- a phrase the markets have taken to mean a minimum of six months. The change in language will set the stage for gradual rate hikes starting in mid-2015.

None of this should come as a great surprise. That said, investors need to recognize that the future of Fed policy is not set in stone. There are still important questions about both the journey and the destination.

Fed officials will be navigating through a fragile global economy, buffeted by economic malaise in Europe and Japan and geopolitical tensions with Russia over Ukraine. With political gridlock rendering governments incapable of pushing through comprehensive measures to fully heal their economies, the task of reconciling economic and policy divergences falls to the currency markets, which will be challenged to do the job in an orderly manner.

As regards the destination, most agree that the Fed's short-term interest-rate will likely end up below its historical average of about 4 percent. How much below depends on the central bank's assessment of the structural factors weighing on the economy's long-term growth potential. These include an aging population, insufficient infrastructure investment, inadequate education and fiscal policies -- such as exemptions-ridden corporate and estate taxation -- that inhibit growth and distort the allocation of productive resources.

For now, though, the Fed can continue bringing its policy back toward normal, albeit gradually, comforted by signs of broadening domestic economic healing.

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