The future of the federal funds rate is “necessarily uncertain,” according to Janet Yellen.
“The future path of the federal funds rate is necessarily uncertain because economic activity and inflation will likely evolve in unexpected ways,” the Federal Reserve Board chair said in a speech to The Economic Club of New York on Tuesday. “For example, no one can be certain about the pace at which economic headwinds will fade. More generally, the economy will inevitably be buffeted by shocks that cannot be foreseen. What is certain, however, is that the Committee will respond to changes in the outlook as needed to achieve its dual mandate.”
In December, the Federal Open Market Committee (FOMC) raised the target range for the federal funds rate, the Federal Reserve’s main policy rate, by a quarter of a percentage point. Since then, the FOMC has remained rather dovish in its January and March meetings.
As shown in those meetings, the pace of rate increases is now expected to be somewhat slower from what was originally projected in December.
The median of FOMC participants’ projections for the federal funds rate is now only 0.9% for the end of 2016 and 1.9% for the end of 2017, both half a percentage point below the December medians.
Despite this change in projections, Yellen emphasized during her speech that the medians of the individual projections for economic growth, unemployment and inflation made by all of the FOMC participants for its March meeting are little changed from December.
She also said the FOMC continues to expect further labor market improvement and a return of inflation to its 2% objective over the next two or three years, consistent with data over recent months.
“This forecast is not a plan set in stone that will be carried out regardless of economic developments,” Yellen told the crowd gathered in New York. “Instead, monetary policy will, as always, respond to the economy’s twists and turns so as to promote, as best as we can in an uncertain economic environment, the employment and inflation goals assigned to us by the Congress.”
Some of the headwinds that continue to restrain the U.S. economy, according to Yellen, include weak foreign activity, dollar appreciation, a pace of household formation that has not kept up with population and income growth and so has depressed homebuilding, and productivity growth that has been running at a slow pace by historical standards since the end of the recession.
“If these headwinds gradually fade as I expect, the neutral federal funds rate will also rise, in which case it will, all else equal, be appropriate to gradually increase the federal funds rate more or less in tandem to achieve our dual objectives,” Yellen said.
Beyond these headwinds, Yellen went into detail about four specific risks that she said could “cloud” the Fed’s current outlook:
1. Global growth, which Yellen said was significantly influenced by developments in China.
“There is a consensus that China’s economy will slow in the coming years as it transitions away from investment toward consumption and from exports toward domestic sources of growth,” Yellen said. “There is much uncertainty, however, about how smoothly this transition will proceed and about the policy framework in place to manage any financial disruptions that might accompany it.”
These uncertainties were heightened by market confusion earlier this year over China’s exchange rate policy.
Weaker foreign economic growth, which is expected, would restrain U.S. economic activity, according to Yellen. However, she added that the effects of slow global growth have been partially offset by the “downward revisions to market expectations for the federal funds rate that in turn have put downward pressure on longer-term interest rates, including mortgage rates, thereby helping to support spending.”