The Federal Reserve meets

The best of all worlds

Dec 17th 2014, 22:33 BY G.I. | WASHINGTON, D.C.

WHAT could be better than an economy converging rapidly on full employment? A central
bank in no mood to get in the way. That is the happy combination America now enjoys, and
it explains the stock market's euphoric reaction to today's meeting of the Federal Reserve.
In the statement releaed after its meeting, the Fed hailed "solid job gains" and diminishing
slack in the labour market. Projections of its officials put unemployment at or below its longrun natural rate a year from now. This is not an economy in need of zero interest rates.
And, as officials had broadly hinted beforehand, they did start to prepare the way for rates
to rise from zero where they have been since 2008. The statement no longer contained the
two-year old pledge to keep rates near zero for a considerable time.
Yet in dropping the statement the Fed went to great pains to reassure that rate increases
were not imminent. Based on its current assessment, the Committee judges that it can be
patient in beginning to normalize the stance of monetary policy, it said. It went on to say
this implied no change in policy from the previous considerable time. Janet Yellen, the
Fed chair, elaborated at a press conference after the meeting: patient meant no increase
for a couple, i.e. two meetings, or about three months.
This left the likely path for interest rates largely unchanged. Ms Yellen left intact
expectations of an initial increase around June next year, and subsequent increases will be
gradual. Projections of interest rates released yesterday put the median officials forecast of
the Federal funds rate at 1.125% by the end of next year and 2.5% by the end of 2016,
which is actually a drop from the 2.875% median forecast in September. This is more than
the market has priced in, but Ms Yellen played down the difference, speculating that the
markets path may be influenced by technical considerations or the incorporation of rather
bad but unlikely scenarios for the economy.

Yet the maintenance of the status for interest rates is actually significant, because it comes
despite significant downward revisions to the forecasts for unemployment: it will fall from
5.8% now to 5.25% at the end of 2015 and 5.1% in 2016 and 2017, i.e. below the 5.35%
rate considered natural. (All these figure are the midpoints of the range of estimates of 17
Federal Open Market Committee members.) Below the natural rate, employers find it
harder to locate workers and wages and prices start to accelerate. A year ago, officials
thought unemployment would still be above 5.5% at the end of 2016.

This would normally represent a solid case to start raising interest rates without delay; and
indeed, one official dissented from the Feds decision on precisely those grounds; another
dissented because he didnt like guidance, period. For the majority, this progress is not a
reason to tighten more quickly because inflation has also dropped. Officials project that it
will be 1.3% next year, instead of 1.75% as projected in September. Core inflation (which
excludes food and energy) will also be lower, though not by as much. Both headline and
core inflation will be at or below the Fed's 2% target for the next three years.
The recent decline is largely due oil. Considering the havoc the price drop has wrought,
most notably on Russia, Ms Yellen was remarkably sanguine. It would, she was confident,
be a net positive for growth since America is a net oil importer. Russias trade and financial
linkages to America were minimal. Experience, she noted, suggests the impact on inflation
will be transitory. Even the drop in long-dated inflation expectations in the bond market,
which might signal eroding confidence in the Feds 2% inflation target, did not bother her: it
could be down to less uncertainty about inflation, or technical factors in bond market.
This nonchalance, however, is somewhat misleading. The impact of oil on headline and
core inflation and inflation expectations has got the attention of the Fed, and was reason
enough for one official, Narayana Kocherlakota of the Minneapolis Fed, to dissent from the
change in the statements language. While Ms Yellen said her base case is still that
inflation moves back to the 2% target, the persistence of inflation for now below target is
ample reason for the Fed to drag its feet on tightening. In response to a question from your
correspondent, she said:

Inflation is running below our objective and the committee wants to see inflation move back
to our objective over time. A short period of very slight undershoot of unemployment below
thee natural rate will facilitate a slightly faster return of inflation to our objective. It is a very
small undershoot in a situation where there is great uncertainty about what exactly
constitutes maximum employment.
In other words, the drop in oil and inflation has given the Fed reason to let the economy run
hotter than it otherwise would. Small wonder that stock markets rallied on the news.