Fed Chair Yellen Case Study

1818 Words 7 Pages
Fed Chair Yellen Begins Fight to Save Her Legacy
During 2016, I have emphasised how difficult it would be for the Fed to wean the US economy off near zero percent interest rates. This is partly due to the globalisation of financial markets and that overseas economies are in no shape whatsoever to withstand higher interest rates. Meanwhile, in recent weeks, it has become increasingly evident that Fed Chair Yellen is keen to avoid her legacy being judged as a disappointment via her inability to raise the federal funds rate. She has duly taken note of the failures of other central banks to raise their policy rates away from zero. As recently as last December, Fed Chair Yellen was confident the federal funds rate could be raised without causing
…show more content…
Meanwhile, financial markets have breathed a huge of relief that Fed policy has seemingly embraced a more dovish posture. The truth is, however, that rate hikes are still possible, but the FOMC is now less inclined to blindly ignore financial market signals. The performance of the real economy does, however, have the higher policy weight. The persistence of uncertainty about the future path of normalisation hinges critically on the FOMC’s assessment of the neutral level for the federal funds rate. Fed Chair Yellen has always argued that, as the economic expansion continues, the neutral policy rate should rise. This has indeed happened, but not at the pace envisaged by the FOMC. This may be explained by the continuation of sluggish economic conditions outside of the US. With respect to the US economy, the flattening of the yield curve since last August’s financial market volatility indicates expectations of easier monetary policy. In order to avoid raising downside economic risks, the Fed consequently needs to ensure that financial conditions do not tighten. The best way to guarantee this outcome is, therefore, to heed to these expectations. This highlights the asymmetric nature of policy risks facing the FOMC. If the economy does slip back into recession, then the current level of the …show more content…
Meanwhile, economists at the International Monetary Fund (IMF) have recently attempted to explain this puzzle. Their conclusion was that the decline in prices had lowered inflationary expectations and the lack of scope that central banks currently had to lower policy rates meant that real interest rates had increased, thereby stifling aggregate demand, output and employment. This appears to be a compelling proposition: the decline in financial market measures of inflationary expectations has coincided with a period of sharply falling oil prices. The trouble is that the positive correlation does NOT necessarily imply causality. The FOMC has never really placed excessive faith in financial market measures of inflationary expectations, hence why they also pay attention to survey-based measures. Meanwhile, many other factors need to be considered, notably the exchange rate in determining inflationary expectations. Appreciating currencies will import deflation and export growth. This is what the Great Currency War is all about. Countries do not want to be presiding over strengthening currencies. Falling oil prices have recently become synonymous with a rising dollar exchange rate. The +20% appreciation in the trade-weighted dollar exchange rate since July 2014 is also culpable of driving inflationary

Related Documents