Fed Has Met Jobs Mandate. On Inflation, Not So Much
Just because the Federal Reserve believes it has reached its objective of full employment and a stable rate of inflation doesn't mean it will be able to accelerate the pace of interest-rate increases.
In a speech this week, Fed Chair Janet Yellen said it was “fair to say” that the economy is moving toward the central bank's goals, and that gradually removing accommodation was warranted. After boosting the federal funds target rate by a quarter-percentage point in December 2015 and by the same amount last month, the Fed's so-called dot plot forecasts indicate that three more hikes are likely this year.
And before you say that Yellen’s dot is the only one that really matters, note that she said in the speech that she had forecast three hikes.
With the unemployment rate now at 4.8 percent -- well within the Fed's central tendency of 4.7 to 5.0 percent -- it's hard to argue that the jobs market isn't humming. But the inflation part of the mandate requires careful attention because the central bank continues to miss its target of 2 percent.
Indeed, the dismal inflation data for November could be described as a wake-up call. The Commerce Department said the core personal consumption expenditures index that the Fed uses to set its inflation forecasts rose 1.7 percent that month compared with a year earlier, down from 1.8 percent in October. The measure also dropped on a one- and three-month basis.
The Fed policy makers' target of 2 percent probably is an overly restrictive interpretation of the mandate. They don’t really believe they can hit that level on a sustained basis. Instead, they likely consider a range of plus or minus 25 basis points around that mark as success. But even given that margin of error, the Fed appears to be falling short.
The Fed’s confidence that it's fulfilling its mandate depends not only on current levels of unemployment and inflation, but its forecasts, too. And as we saw from the central bank's Summary of Economic Projections, policy makers anticipate that they will be within the margin of error in 2017 and will reach the 2 percent target in 2018. What gives the Fed confidence in that forecast are the current and projected undershooting of the unemployment rate relative to its natural rate. This is a key passage from the most recent Fed minutes:
Participants generally viewed the information on inflation received over the intermeeting period as reinforcing their expectation that inflation would rise to the Committee's 2 percent objective over the medium term.
The Fed can take comfort because the 0.2 percent increase in the core consumer price index for December means that the weak November number for the Fed's PCE target won't likely be repeated.
The actual amount of tightening will ultimately depend on the evolution of the forecasts for unemployment and inflation. If the expectation for unemployment drifts lower for this year, for instance, the median dots are likely to shift higher to ensure that the Fed continues to meet its mandate.
The current shortfall of inflation relative to target doesn't deter policy makers from their belief that, for all practical purposes, they have almost achieved their dual mandate. But acknowledging this fact doesn't imply a faster pace of rate increases. The policy necessary to keep economic conditions consistent with meeting the dual mandate is already built into the rate forecast. The accuracy of that forecast ultimately depends on the actual economic outcomes this year.
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