Pub. 5 2015 Issue 4

Therefore, in trying to gauge the under- lying trend in inflation, I find it useful to follow measures that strip out the volatile components that may reflect temporary or special factors. My preferred measure is the trimmed mean rate constructed by the Dallas Fed. That actually shows the un- derlying inflation rate for the past year to be 1.7 percent—still below our 2 percent target, but not by much. Looking ahead, as the effects of the dollar and oil prices ebb, and as the economy strengthens fur- ther, I see inflation moving back up to our 2 percent goal within the next two years. My forecast has some upside risks, specifically an even stronger and faster rebound in housing. And there are, of course, the downside risks: the threat of slowdowns and spillovers from abroad, or the dollar appreciating further. NORMALIZING POLICY These developments factor into the question of whether or not to raise rates. A considerable amount of ink has been spilled on the subject, and just about everyone has an opinion. Which, of course, I’m always delighted to hear. Our decisions are based on a careful analysis of two sides of the ledger: the one that argues for a little more patience and the one that prefers the “sooner rather than later” approach. On the patience side, there are two main concerns. First, there’s what we call the constraint of the “zero lower bound.” That is, rates are essentially zero right now and can’t go much lower. If the econ- omy slows or inflation falls even further, we don’t have much room to lower rates. Conversely, it’s much easier to respond to a move in the other direction: If growth or inflation pick up quickly, we can raise rates without difficulty. 1 Second, there’s inflation, which has stayed stubbornly below our 2 percent target for nearly 3½ years now. The infla- tion conundrum is not unique to the U.S.; it’s a problem in virtually every part of the world. And while we can ultimately control our own inflationary destiny, as it were, there’s no question that globally low inflation, and the policies other countries have adopted to combat it, has contrib- uted to downward pressure in the U.S. As I said, I see inflation bouncing back. But forecasts aren’t guarantees, and there is always the risk that it could take longer than I expect. Some ask: “What’s the rush to raise rates when inflation has been persistently so low?” That brings me to the other side of the issue, the arguments for raising rates sooner rather than later. Milton Friedman famously taught us that monetary policy has long and vari- able lags. 2 Research shows it takes at least a year or two for monetary policy to have its full effect. 3 So the decisions we make today have to aim for where we’re going, not where we are, and the economy is a moving target. We can’t wait until we see the whites of inflation’s eyes; if we did, we would overshoot the mark. An earlier start to raising rates would also allow a smoother, more gradual process of policy normalization, giving us space to fine-tune our responses to any surprise changes in economic conditions. If we were to wait too long to raise rates, the need to play catch-up wouldn’t leave much room for maneuver. Not to men- tion, it could roil financial markets and slow the economy in unintended ways. Finally, experience shows that an economy that runs too hot for too long can generate imbalances that ultimately lead to either excessive inflation or an economic correction and recession. In the 1960s and 1970s, it was runaway inflation. In the late 1990s, the expansion became increasingly fueled by euphoria over the “new economy,” the dot-com bubble, and massive overinvestment in tech-related industries. And in the first half of the 2000s, the economy was propelled by irrational exuberance over housing, sending house prices spiraling far beyond fundamentals and leading to massive overbuilding. If we wait too long to remove monetary accommodation, we hazard allowing these imbalances to grow, at great cost to our economy. So those are the main arguments on both sides of the ledger. My view has been, as all my economic views are, data-driven. In the past, I found the arguments for greater patience to clearly outweigh those for raising rates. The labor market was still far from full strength and the risk to the recovery’s momentum was very real. As the economy closed in on full employment, the other side of the ledger started gaining greater weight and the arguments moved into closer balance. My forecast is that we’ll reach our maximum employment mandate in the near future and I’m increasingly confident that inflation will gradually move back to our 2 percent goal. It makes sense, therefore, to start gradually moving away from the extraordinary stimulus that got n The Fed — continued from page 9 10 www.azbankers.org