The Fed's New Normal
Looking forward to 2016.
Wednesday's announcement that the Federal Reserve will raise its benchmark interest rate by a quarter of a percentage point may be the most widely anticipated news in the history of U.S. monetary policy. Had Fed Chair Janet Yellen said anything else, investors would have been stunned.
All the pre-event chatter made the move mandatory. Fortunately, the decision was also correct, because slack in the labor market has diminished to the point where monetary policy needs to gradually get back to normal. That said, this new course won’t be easy. U.S. economic policy faces three big tests over the coming months.
First, the Fed has to make sure interest rates rise without incident, and that task is far from straightforward. The Fed will be trying to normalize monetary policy in conditions that are anything but normal.
The central bank's quantitative-easing program has swollen its balance sheet and injected trillions of dollars into the economy. Yet to raise interest rates, the Fed needs to create a controlled shortage of money. New financial regulations add a further complication, because they're affecting the market for safe liquid securities. In short, the Fed will be using new techniques in different financial markets, and how well they will work remains an open question.
Second, the Fed must guide investors on what to expect next. This poses difficulties, too. The Fed needs to insist -- and keep insisting -- that there's no fixed schedule for further rate increases, that data not dates will drive policy and that rates can go back down if need be. Its new policy statement says as much, but relentless consistency on these points is vital.
Bear in mind, the Fed tried to send the same message before, but the information got blurred in transmission: Investors came to expect a first interest-rate rise by the end of this year regardless. As it turned out, economic data aligned with that expectation -- but the Fed should never put itself in that position again. It shouldn't have to choose between what the data require and what markets have come to expect based on the calendar.
The third challenge is not for the Fed but for Washington's other policy makers -- if calling them policy makers isn't too much of a stretch. The Fed cannot carry the whole burden of macroeconomic policy, least of all under current conditions. The recovery is far from robust; despite the fall in headline unemployment, there's little sign of wage or price inflation. It would be foolish to rule out new economic setbacks. Interest rates are still close to zero, and renewed QE would arouse financial-stability concerns, so the Fed would lack good tools to respond.
What else is there? The answer is fiscal policy -- an especially powerful countercyclical weapon in conditions like these. Yet in its protracted negotiations over spending measures and its endless back-and-forth on tax policy, Congress never so much as considers the macroeconomic dimension. Perhaps it's a waste of breath to say it, but anyway: If this neglect persists, the U.S. will pay a heavy price.
For the past several years, the Fed has been asked to do it all. Under difficult conditions it has acquitted itself well. In the future, out of choice or dire necessity, Washington's approach to economic policy will have to change.
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