The Federal Reserve Is on Shifting Ground

(Bloomberg) -- The biggest short-term threat to the U.S. economy comes from President Donald Trump’s dangerous maneuvers on trade, not the Federal Reserve’s monetary policy. But knowing this doesn’t much help the Fed do its job, which is getting more complicated for reasons closer to home: The outlook for inflation is shifting, and Fed officials are wondering how to respond.

At their meeting this week, they unanimously decided to leave interest rates unchanged. That was expected, mainly for scheduling reasons. In March, they raised the policy rate a quarter of a percentage point, to 1.5 percent to 1.75 percent, and this week’s timetable allowed for no press conference to explain a further rise. Investors are expecting another small increase in June, then one or two more by the end of the year.

With a pointless fiscal stimulus in the pipeline, the economy at or near full employment, wages rising faster, and inflation back at the Fed’s 2 percent target, the question is whether that will be enough.

At the March policy meeting, officials said they were confident inflation was heading back up to target. Figures published last month revealed it was already there. Recent figures show that wages and salaries are rising quickly too, faster now than they have for 10 years. Slack in the labor market appears to be running out — not exactly surprising, with the unemployment rate at barely 4 percent. And after a protracted (albeit slow) recovery, the economy is still growing steadily, at a rate of more than 2 percent. 

Yet, as the Fed puts it, monetary policy remains “accommodative.” The policy makers’ new official statement (minutely parsed by investors for clues about future intentions) says the inflation target is “symmetric,” suggesting that they expect inflation to run at least a little above target this year. And that’s the emerging problem — reconciling the prospect of above-target inflation with policy that’s expected to be accommodative for many more months.

The Fed’s basic thinking isn’t wrong — yet. Without clearer signs that inflation is moving persistently above 2 percent, it would be a mistake to move monetary policy from the track of gradual tightening that officials have led the markets to expect. Persistent undershoots were tolerated; a temporary overshoot, if it happens, needn’t cause alarm. And a shift in policy that took markets by surprise could easily do more harm than good, especially with investors watching the White House as a risk factor.

Nonetheless the Fed needs to keep a careful eye on investors’ expectations of inflation. Estimates have moved higher lately (the 10-year break-even measure stands at a little over 2 percent) though officials deem them to remain “low.” Next month, as well as delivering the expected rise in interest rates, the Fed should acknowledge more plainly that conditions are changing. It continues to assure that the risks to its forecast are “roughly balanced.” If that formula isn’t already out of date, it soon will be.    

—Editors: Clive Crook, Mary Duenwald.

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