delong241_Kent Nishimura  Los Angeles Times via Getty Images_federalreserve Kent Nishimura/Los Angeles Times via Getty Images

Why the US Federal Reserve’s Options Are Limited

The US Federal Reserve's Federal Open Market Committee ought to announce a rate increase that is large enough to bring its policy rate to an optimal neutral-plus level. But it has an even greater interest in adhering to its own forward guidance, implying that it will probably maintain its incremental approach.

BERKELEY – What policy will the US Federal Reserve announce after the Federal Open Market Committee’s two-day meeting this week, and what policy should it announce?

The first question is easy: There is a high probability – 75% – that the Fed will follow its previous forward guidance and raise its target for the short-term safe nominal interest rates that it controls by 50 basis points, from 0.75-1% to 1.25-1.5%. By validating its previous statements, the Fed hopes to steer the economy in the desired direction by shaping expectations of future interest rates.

Because this “jawboning” strategy is effective only insofar as the Fed’s forward guidance is trusted, building and maintaining that trust is a major policy objective in itself. The Fed should deviate from previous forward guidance only if there is substantial evidence that the economy is on the wrong track. Currently there is no such evidence. Bond-market expectations of the underlying long-run consumer price index inflation trend remain under 2.5% per year – which is lower than in the pre-2014 period, when no rational person had any reason to fear that CPI inflation would soon deviate upward from its target.

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