Interest Rate Directionality and the Fed
Tim McLaughlin, VP, Weichert Financial Services.
The Federal Open Market Committee is ‘evaluating the impact of recent economic reports and gauging if that impact is grounds enough to change its outlook on interest rates’, Federal Reserve Chair Janet Yellen said in a speech Wednesday at the Economic Club of New York. “The unusually harsh winter weather in much of the nation has complicated this judgment, but my FOMC colleagues and I generally believe that a significant part of the recent softness was weather related,” Yellen said.
As a result, Yellen listed three questions that are likely to loom in the FOMC’s ongoing assessment of whether the economy is on the path back to maximum employment and price stability.
1) Is there still significant slack in the labor market? “One of the FOMC’s objectives is to promote a return to maximum employment, but exactly what conditions are consistent with maximum employment can be difficult to assess,” Yellen said. Currently, the unemployment rate at 6.7% is slightly more than 1% above the 5.2% to 5.6% central tendency of the committee’s projections for the longer-run normal employment rate, which will take more than two years to close. The FOMC explained that it will need to monitor labor market indicators like wage pressures and labor-force participation to judge how much slack remains and, therefore, how accommodative monetary policy should be.
2) Is inflation moving back toward 2%? Inflation continues to fall below 2%, which could pose risks to economic performance. The committee works to avoid inflation dropping too far below its 2% objective because, at very low inflation rates, adverse economic developments could more easily push the economy into deflation. “FOMC is well aware that inflation could also threaten to rise substantially above 2%. At present, I rate the chances of this happening as significantly below the chances of inflation persisting below 2%, but we must always be prepared to respond to such unexpected outcomes, which leads us to my third question.”
3) What Factors may push the recovery off track? “Over the nearly 5 years of the recovery, the economy has been affected by greater than expected fiscal drag in the United States and by spillovers from the sovereign debt and banking problems of some euro-area countries,” Yellen said. “Further, our baseline outlook has changed as we have learned about the degree of structural damage to the economy wrought by the crisis and the subsequent pace of healing,” she added.
These three key drivers will be the lynchpin for the timing and directionality of Fed driven interest rates in the short to medium term.’
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