Fed Walks the Expectations Line

By JUSTIN LAHART

Sept. 17, 2014 5:52 p.m. ET

The Federal Reserve doesn't plan on getting back to normal anytime soon.

On Wednesday, its rate-setting committee once again said it doesn't plan on raising the target range for overnight interest rates for "a considerable time."

That defied the expectation of many economists that it would dial back such language in preparation for tightening policy next year. Nor did the Fed change its wording about "significant underutilization of labor resources," despite a growing belief much of the decline in the labor-participation rate—the share of the population working or looking for work—is here to stay.

One possible factor behind the Fed's decision to stay its hand: Inflation readings remain remarkably cool. Indeed, the Labor Department on Wednesday reported that its index of consumer prices fell 0.2% in August from July, while its core reading, which excludes food and energy prices, was flat. That implied the Fed's preferred measures of overall and core prices were both up just 1.4% from a year ago, according to J.P. Morgan. This is well below the 2% inflation rate the Fed is targeting.

The low levels of inflation suggest there is still plenty of slack in the labor market, and the economy therefore continues to run well below potential. Moreover, the Fed would like a bigger inflationary buffer to minimize the risk of deflation the next time a recession strikes.

When the Fed does start raising its rate target—expected sometime next year—from the zero-to-0.25% range it has held since 2008, it expects to move very gradually.

Fed Chairwoman Janet Yellen pointed out in her news conference that the bulk of Fed policy makers project that at the end of 2016 the unemployment rate will range from 5.1% to 5.4%, a bit below their estimates for its natural rate. Meanwhile, they foresee inflation nearing their target. But the median forecast for overnight rates is about 2.9%, well below the longer-run projection of 3.75%.

One reason is that the Fed thinks the wounds from the recession and financial crisis still won't have fully healed. Another may be that it is taking pains to convince financial markets that tightening will be gradual.

But the line between convincing investors rates won't stay near zero forever and keeping them from jumping the gun could prove very thin.