Yellen’s Wish May Not Come True

The Federal Reserve expects to raise rates gradually. If the unemployment rate keeps falling, that plan might not hold up

By Justin Lahart

Federal Reserve Chairwoman Janet Yellen testified on Capitol Hill in Washington on Wednesday. While the Fed has championed a ‘gradual’ pace on interest-rate moves, a possibly overheating job market may complicate decisions later in the year. Photo: Jacquelyn Martin/Associated Press


The word of the day at the Federal Reserve is “gradual.” It might not be the word of tomorrow.

In congressional testimony Wednesday, Fed Chairwoman Janet Yellen noted that the central bank has “gradually” tightened policy this year, that “additional gradual rate hikes” are likely in the years to come, and that policy makers intend to “gradually reduce” the Fed’s bondholdings.

“Gradual” is the stuff of central banker dreams, but up until late last year the Fed struggled to realize them. Whether it was the 2013 taper tantrum or the global credit worries that hit early last year, the Fed’s plans to wean the economy off its easy-money policies were repeatedly thwarted.

With the U.S. and global economies on better footing, it is unlikely the Fed will be forced to delay its tightening efforts. The bigger risk is that falling unemployment will force the Fed to raise rates faster than either it or investors expect.

The unemployment rate, at 4.4%, is a bit below what Fed policy makers think is its long-run, just-right level for the economy. But slow wage growth and low inflation raise the possibility the right rate might be even lower than it is today. If the unemployment rate were to slowly drift lower, the Fed might be open to sticking to its “gradual” guns and finding out what the right rate is.

The problem is the drop in the unemployment rate has been anything but gradual. It is nearly a half point lower than it was at the start of the year, and at the recent pace of hiring it could fall below 4% by January. That would put the Fed in a situation where it had to guess whether the labor market was overheating.

The consequences of guessing it wasn’t overheating, and being wrong, would be dangerous. The Fed would then need to raise rates sharply in an effort to push the unemployment rate higher.

And, as Bank of America Merrill Lynch economist Ethan Harris points out, increases in the unemployment rate of a few tenths of a percentage point are usually followed by recessions.

Instead of running that risk, the Fed would probably raise rates faster than it now has mapped out. Investors’ surprise at this wouldn’t be gradual.

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