The Fed's Job Is About to Get Harder
Jerome Powell, chairman of the U.S. Federal Reserve, writes in a notebook during a meeting with the Board of Governors for the Federal Reserve in Washington, D.C., U.S. (Photographer: Aaron P. Bernstein/Bloomberg)

The Fed's Job Is About to Get Harder


(The Bloomberg View) -- The interest-rate decision that the Federal Reserve will announce on Wednesday is pretty straightforward. The central bank has led financial markets to expect another quarter-point increase in its benchmark rate, lifting the target range to 1.75 percent to 2 percent. This will do, for now.

Further ahead, things look a lot more complicated. Tough questions loom for the Fed’s policy makers, and most of them boil down to this: What should the new normal for monetary policy look like?

Raising interest rates another notch this month, the seventh increase since December 2015, is easy to justify. Monetary policy is still providing stimulus, even as the labor market tightens and wages show the first signs of picking up. Further tightening is correct. When and how this sequence ought to end, though, is much harder to say.

There’s uncertainty, to begin with, over whether the economy is already at (or beyond) full employment. The unemployment rate has fallen to 3.8 percent, which is startlingly low by historical standards. But the signs of rising wages that typically give warning of an uptick in inflation are still only tentative.

Also, despite that low unemployment rate, the U.S. rate of employment — the share of the working-age population with jobs — is also low, by the economy’s own historical standards and in comparison with other countries. This suggests there might still be a little post-crash slack in the labor market, and that continued monetary stimulus might draw back into the workforce more people who’d given up looking for jobs.

The uncertainty doesn’t end there. Once full employment has truly returned, you’d want monetary policy to stand at neutral — neither raising nor lowering the level of demand in the economy. Unfortunately, the meaning of “neutral” monetary policy is currently no clearer than that of “full employment.”

Not long ago most economists would have put the neutral short-term rate of interest at around 4 percent. Today they’d say it’s between 2.5 percent and 3 percent. Two more quarter-point increases — this month’s and the next, perhaps in September — would put the policy rate close to the bottom of this range, thereby raising the question, “Is that it?

The decline of the neutral rate of interest is a mystery in its own right. A permanent lowering of the economy’s trend rate of growth could account for it; so could a persistent surplus of global savings, due in turn to demographic and other factors. But if the trend rate of growth should recover, or if investment were to surge back, the neutral rate might rise again, obliging the Fed to push interest rates higher than it currently expects.

Taken together, these questions lessen the scope for useful forward guidance about the Fed’s intentions. The central bank needs to stay open-minded not just about data on prices and jobs as it arrives but also about these underlying uncertainties.

It should focus primarily on guarding against inflation, leaving investors in no doubt that that’s the priority. Farther ahead, though, the full extent of future tightening will depend on an understanding of the post-crash economy that remains a work in progress. Confident predictions about things that aren’t understood are not conducive to financial stability. 

The Fed and its watchers may not like it, but that’s the reality. Ten years on, the legacy of the crash — deep uncertainty about what has changed and what has stayed the same — continues to confound economic policy.

©2018 Bloomberg L.P.

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