The Federal Reserve’s final meeting of 2015 is just a few weeks away, and with the markets betting that the central bank will finally raise interest rates this month, knowing what’s on the mind of Fed Chair Janet Yellen is more important now than ever.
On Wednesday, Yellen gave speech at the Economic Club of Washington, D.C. in which she gave insights into her thinking on the economy. Here are three key takeaways:
It’s not time to declare the job market healed: One consistent point of confusion on Fed policy is how it justifies keeping interest rates at near zero even when the unemployment rate is down to 5%, which is below its post-war historical average and roughly at the Fed’s own estimate of full employment.
Yellen argued that because there are roughly 2 million people who say they want a job, but have given up looking for work (a much larger share of the adult U.S. population than in the past), and because there are elevated levels of part-time workers who want full time jobs, there is more “slack” in the labor market than a 5% unemployment rate would suggest. This is why, Yellen says, we haven’t seen significant wage gains of late despite a historically low unemployment rate.
The Fed is likely to go ahead and raise rates anyway: One of the difficulties Federal Open Market Committee members have when trying to hit an inflation target is that inflation doesn’t manifest until well after the the conditions for inflation have been created. So even though there might be significant slack remaining in the labor market, Yellen said it’s important for the Fed to start normalizing interest rate policy to head off inflation that would surely occur down the road if rates were kept too low indefinitely.
The days of 6% interest rates are long over: At the same time, Yellen stressed that markets should not expect the pace of interest rate increases to be as fast as they have been during previous tightening cycles. Said Yellen:
In other words, the Fed’s job is not just to control interest rates, but the public’s perception of where interest rates will be in the future. And given that shaping public perception is tricky business, the Fed might be forced to keep rates lower for longer than it otherwise might. This means that the Fed might need to allow inflation to rise higher than its target, and that the unemployment rate might fall below the Fed’s long term goal for a period of time.
In additon, Yellen pointed to research that shows that the “neutral rate of interest,” or the interest rate goal which would be neither expansionary or contractionary when the economy is operating at full potential, is much lower than in economic eras past. The Fed expects interest rates to top out at around 3.5% in the long run, much lower than the average federal fund rates in previous decades.