Janet Yellen is many things: an economist, a regulator, the chief administrator of a sprawling government agency. Her decision to raise interest rates on Wednesday, however, shows her wearing a different hat: risk manager.
The quarter-point increase to the Fed's target for rates may have been as long-awaited, intensively discussed and thoroughly telegraphed a monetary policy action as any in history. So much so that after seven years of having the interest rate target near zero, the quarter-point rise was a little anticlimactic. Yellen, the Federal Reserve chairwoman, exuded confidence about the strength of the country's economic expansion, describing the rate rise as a reflection of the economy's having come, in her words, "a long way" as it marches steadily toward full health.
One major risk is that the announcement will turn out to be a “Mission Accomplished” moment for the Fed. Maybe the struggling global economy will hold back the US more than Yellen expects, inflation will remain well below the Fed’s 2 per cent target, and it will have to reverse course, as have several global counterparts that have raised interest rates prematurely in the last few years.
So one argument is that the Fed should have waited until inflation was more clearly rising before taking its foot off the accelerator of the US economy. As the central bank’s chief risk manager, Yellen was persuaded by a different sort of danger.
Overheating risk
If the Fed had waited another several months, to the point where the economy was at real risk of overheating, with inflation rising significantly, it might have needed to increase rates sharply to try to head it off. And when moving quickly, there would surely be bigger disruptions to financial markets and greater risk of miscalibration and raising rates too much, choking off the economy altogether.
“Such an abrupt tightening could increase the risk of pushing the economy into recession,” Yellen said on Wednesday afternoon. By tightening the money supply now, the Fed can move more gradually, taking time to see how higher rates affect the expansion and whether inflation really is returning to normal. The baseline situation, based on communications the Fed published on Wednesday, appears to be that the central bank will raise rates another quarter percentage point every other meeting in 2016, getting short-term interest rates to just shy of 1.5 per cent a year from now.
“In between moves,” said Beth Ann Bovino, chief US economist for Standard & Poor’s Rating Services, the Fed’s policy committee “will be able to gauge how the economy absorbs the shock. Sticking with their mantra, that it depends on the data, as economic conditions strengthen further, the Fed will continue to raise rates gradually through the year."
Slowing it down
But the Yellen Fed is explicitly holding out the possibility of slowing that down if inflation doesn’t pick up.
“If incoming data led us to call into question the inflation forecast that we have set out,” she said in a news conference, “that would certainly give the committee pause.”
If the baseline is that the Fed raises interest rates a quarter percentage point at every other meeting in 2016, the interesting question is whether circumstances warrant accelerating that (doing half a per cent at one or more meetings, for example) or skipping a meeting so that rates stay lower longer.
In response to a question, Yellen emphasised that when central banks caused recessions in the past, it was often because they did not raise interest rates early enough and later had to tighten monetary policy even more aggressively to make up for the earlier error. She is determined not to take that chance.
That is the rate increase rationale that she is willing to talk about publicly. There are two other dimensions of risk management that lurk in the background. First, she can not make decisions unilaterally. She is only the first among equals as chairwoman of the Fed’s policy committee. So keeping as many of her colleagues on board with her policies is important in wielding power. Wednesday’s action shows her colleagues who have been itching to raise rates for some time ? some of them out of fear that they are fueling financial bubbles ? that she is responsive. It buys some credibility to keep the path of rate rises a shallow one if she thinks it is warranted in 2016 and beyond.
Presidential campaign
Second, while the Fed makes its decisions apart from politics, officials there would rather not make a major policy pivot in the heat of a presidential campaign. By starting a rate increase cycle now, before primary voters start going to the polls, the Fed does not have to pull the trigger for the first time when its actions are more likely to become a political football.
Finally, there is the matter of the Fed’s credibility. Fed officials have spent the last 18 months or so predicting that there will be an interest rate increase in 2015, and with the year about to end, this is the last chance to make that prediction come true. That is no excuse if the decision turns out to be a bad one, for example if the economy slows significantly in 2016 and the Fed must reverse course. But when something is a close call, as this decision was, it could tip the balance toward action.
There can be no assurance that the Yellen Fed has made the right move. Certainly, smart economists at places such as the International Monetary Fund think that patience would have been rewarded. There are always economic risks out there. The question for the US economy is whether, by focusing on the danger of having to raise rates faster later, Yellen has chosen the right risk to focus on.
