Don't Ignore What the Fed Doesn't Know
The Federal Reserve is about to take another small step toward getting U.S. monetary policy back to normal. The only catch is that, as with politics and the economy, no one really knows what "normal" means anymore.
So far, investors have viewed this unusual situation calmly, and the Fed is hoping this doesn't change. But calm can become complacency -- and that's a growing risk for the U.S. economy.
Recent Fed actions have stayed in line with the expectations the central bank previously engineered. For this week's policy announcement, that points to no change in interest rates (market-based measures of the chance of an increase this month are around one in 10, rising to one in two for an increase in December), and the start of a well-trailed, years-long program to shrink the central bank's engorged balance sheet.
But the risks are greater than the Fed's patient gradualism may suggest. Expectations need to be kept in line with economic reality.
Remember that the Fed's current policy is still extraordinarily accommodative. Short-term interest rates stand at zero in inflation-adjusted terms, and the central bank's $4.5 trillion balance sheet provides additional financial ease. Meanwhile the economy, now in its eighth year of slow but steady expansion, is at or close to full employment, and the stock market stands at record highs. Inflation is still subdued -- but, since monetary policy acts with a long lag, the Fed can't afford to wait until prices are rising briskly before it acts.
There's no denying the uncertainties. At the same time, it's worrying that the Fed isn't further along in its effort to normalize policy. On balance, a quarter-point rise this month is warranted, and the Fed should have prepared investors for it.
As well as gently increasing interest rates and unwinding its earlier bond-buying program, the Fed also needs to be frank about future risks for monetary policy, so that investors don't take too much for granted.
Two unknowns, in particular, need to be acknowledged. First, it's unclear where short-term interest rates should settle once this adjustment is complete. This depends on future growth prospects and the puzzling behavior of wages and inflation, among other things. A second unknown is the eventual right size of the Fed's "normal" balance sheet. It's sure to be bigger than before the Fed's bond-buying program began, because of changes in the way the central bank conducts day-to-day monetary policy. (The new approach requires more holdings of bank reserves.) How much bigger, the Fed doesn't yet know.
With so much added uncertainty, surprises are guaranteed. Resilience in the face of such surprises will be more valuable than false confidence. The Fed and its critics should bear this in mind as it struggles to do the impossible: steer the economy with the limited tools at its disposal, while the other branches of government conspire to make its job harder.
--Editors: Clive Crook, Michael Newman.
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