A Changing Economy Challenges the Fed

by: Cliff Waldman, Chief Economist

As expected, the Federal Open Market Committee, the Fed’s monetary policy body, announced an increase of 25 basis points in the target for its consequential federal funds rate. Today’s action is only the fourth time since the economy bottomed in June 2009 that that Fed has acted to remove its extraordinary monetary accommodation. The slow effort to normalize policy will now include a gradual and predictable mission to shrink the Fed’s outsized balance sheet, but not completely to the size it was before the world shock of a near financial collapse. Many financial market participants have expressed concern about the balance sheet adjustment. The Fed made it clear that this will be a transparent, slow, and predictable process.

The world has changed for America’s central bank. Those who watch this critical economic policy institution, arguably the most powerful on earth, are used to seeing assertive and sometimes volatile adjustments as the economy recovers from downturns. The pre-crisis Fed would react quickly to an economic recovery and a falling unemployment rate to ensure that tightening labor market conditions would not accelerate wage and price inflation to the point of creating growth-killing instabilities.

In this post-crisis era, however, the Fed is keeping financial markets stable and lecturing on the unusual uncertainty it faces as it deals with the seeming breakdown of long-standing relationships. Who would have thought, for example, that a 16-year low unemployment rate would accompany still nagging concerns about inflation being too low? And, it might have sounded strange to hear Fed Chair Janet Yellen, in this afternoon’s press conference, describe the economy as being “strong” with such sluggish GDP growth in recent quarters.

It seems clear that the Fed will stay on a path of moderate increases in policy interest rates. Janet Yellen is banking on the risk of pre-crisis normality being just around the corner and does not want to get caught in a position where inflation starts to accelerate with a too low fed funds target. This could force a potentially destabilizing scenario where policy will have to quickly catch up to reality. However, Yellen’s tone suggests that the talented professionals at the Fed are doing much the same as the rest of us-trying to learn what we can about the world where fundamental changes in demographics, technology, supply chains, trade, and politics are challenging us all.