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10 10 2015 | by Victor Xing | Central Banks

Does the Federal Reserve “need” to begin policy normalization?

Some observers argued that the economy seems to be growing under Federal Reserve's accommodative monetary policy. Are there reasons for the Federal Reserve to raise rates and begin removing policy accommodation?

The Federal Reserve has two objectives:

  1. Stable prices in the form of Personal Consumption Expenditure (PCE) at 2% YoY
  2. Maximum employment

Federal Reserve policymakers commented on the employment mandate in its September meeting Minutes:

Participants agreed that labor market conditions had improved considerably since earlier in the year. Payroll employment had been increasing steadily. Underutilization of labor resources had diminished along a number of dimensions: The unemployment rate had fallen to a level close to most participants’ estimates of its longer-run normal rate, and the numbers of discouraged workers and those employed part time for economic reasons had moved lower. With the cumulative improvement in labor market conditions, most participants thought that the underutilization of labor resources had been substantially reduced, and a few of them expressed the view that underutilization had been eliminated. But some others believed that labor market slack in addition to that measured by the unemployment rate remained and that further progress was possible before labor market conditions were fully consistent with the Committee’s objective of maximum employment

In other words, the maximum employment mandate is close to being met.

The concern is on inflation, and FOMC participants projected inflation to reach between 1.5% to 1.8% PCE in 2016.  Since monetary policies work with a lag, policymakers would prefer to initiate rate hike before inflation reaches 2% PCE.

September FOMC SEP
September FOMC SEP

Therefore, the FED is all about conducting policies according to its projection of employment and inflation.  One can critique whether they are right about their projection (and they have been revising down their projections for the past couple meetings), but the FED has been very consistent in its pursuit to meet its dual mandate.  If the Federal Reserve projects economic conditions on path to meet its dual mandate, then the central bank may lean toward removing accommodation and begin policy normalization.

Next article10 10 2015 | by Victor Xing | Central Banks

What monetary tools can the FOMC use to fight the next recession?