Fed Chair Janet Yellen has reported that the U.S. economy is healthy enough for the Fed to raise rates and to begin tackling its massive bond portfolio. However, Yellen also cautions that a low inflation and a low neutral rate may leave the central bank with diminished leeway.
Yellen appeared before Congress to depict an economy that is still continuing to grow despite its slow pace. These incremental growths have continued to add jobs while simultaneously benefiting from a steady household consumption and a recent jump in business investment. The economy is even now continuing to be supported by stronger economic conditions abroad, according to Yellen.
In response to such a positive economic climate, coupled with the anticipation for a persistent evolution of the economy, the Fed believes that the current economic environment warrants gradual increases in the federal funds over time. This will, in turn, lead to reductions in the Fed’s portfolio of more than $4 trillion in securities, which have been stated to begin later this year.
Yellen notes that given current fund estimates, the federal funds rate would not require a dramatic increase before reaching a neutral level that neither encourages nor discourages economic activity. This neutral state is important as it ensures a more balanced status quo that does not require tinkering on the Fed’s part, therefore allowing business to be conducted in a more sustainable and predictable manner.
The Fed is leaning towards a looser or accommodating monetary policy, which would result in a lower neutral rate. To compensate for this, the Fed may be compelled to slow down the pace of rate incremental increases, but as to whether the ultimate rate stays the same but just over a longer duration or the rate is reduced remains to be seen.
Yellen has responded to doubts voiced by lawmakers and informed the House Committee on Financial Services that she expects the gradual reduction of the balance sheet will refrain from having drastic effects in markets, ensuring that all operations and practices are smooth moving forward. A reduction in the balance sheets will allow the economy and federal rates to diverge from crisis-related policies.
There is opposition from lawmakers who believe that the Fed is able to exercise too strong an influence over the economy through the tailoring of rates that results in an unnatural progression of the economy’s state. These lawmakers propose the further use of mathematic formulas to discern the rates, moving from a more rule-based monetary formula to one that is independent of the agency behind it.
As with all opposition, this has been met with criticism, as Committee Chair Jeb Hensarling compliments the work that the Fed has produced, expressing respect for the comparisons between rule-based monetary policies with some of the more common formulas. While this discussion remains in its infantile stages as far as the current economic climate is concerned, perhaps a combination of both rule-based policies with the relevant monetary formulas will establish the best results.
Yellen herself responded to such criticisms by stating that their current regulatory agenda is rather light. In fact, there are plans to ease some of the requirements imposed on banks boards of directors following the financial crisis. Furthermore, Yellen has expressed concern over proposals that policymakers worry may grant elected officials influence over what are supposed to be independent Fed interest rate decisions.
It is difficult to predict what the results of this discussion will be, especially considering that Yellen will soon be replaced when her term ends in February. However, Yellen is positive about the end of her term, as the economy appears to be a continuous cycle of hiring, spending, and investment that should foster a stronger pace of wage and price increases.
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