The Fed is Ready to Raise Rates: Will Past be Prologue?

• DOI: http://doi.org/10.1111/1468-2362.12059
• Date: 01 March 2015
• Author: Richard Clarida
• Published date: 01 March 2015

COMMENTARY

The Fed is Ready to Raise Rates:

Will Past be Prologue?

Richard Clarida

C. Lowell Harriss Professor of Economics and International Affairs,

Columbia University, New York, NY, USA, and Former Assistant Secretary

for Economic Policy, US Treasury.

Abstract

The Fed is likely to commence hiking its policy rate in 2015. It is unlikely,

however, that this rate-hike cycle will feature a predictable 25 basis-point

rise at each and every meeting once it begins. Instead, the Fed will, I

believe, opt to deliver a path of policy normalization even more gradual

than the path it delivered in 2004–06. This will be owed, at least in part,

to the difficulty it will confront in estimating the neutral policy rate

with any precision, as well as to the fact that this cycle is likely to begin

with an inflation rate that will have been running below its 2% target

since that target was first announced in 2012. The Fed will nonetheless

begin to hike because it is forecasting that inflation will rise as unemploy-

ment falls to –or even below –its estimate of the non-accelerating

inflation rate of unemployment (NAIRU). Because of the slowdown in

the United States and global potential growth, however, as well as a

International Finance 18:1, 2015: pp. 93–107

DOI: 10.1111/1468-2362.12059

© 2015 John Wiley & Sons Ltd

persistent excess of global saving relative to desired investment opportu-

nities, I expect that, for at least the next couple of years and likely for

some time beyond, the neutral Fed policy rate consistent with mandate-

implied levels of unemployment and inflation will lie in the range of

2–3% in nominal terms, well below the pre-crisis estimates of 4%.

I. Introduction

The flow of economic data, state ments by Fed officials and market pricing all point

to the likelihood that the Fed wil l begin to raise short-ter m interest rates sometime

in 2015. If so, this will be the first Fed rate-hike cycl e since the one that commence d

in June 2004 under Alan Greenspan and concluded in May 2006 under Ben

Bernanke. At the ri sk of understatement, a lot has certai nly happened si nce then –

afinancial crisis coincident with a ‘great’recession that tog ether tri ggered an

aggressive monetar y policy respons e, with the Fed cutting t he short-term polic y

rate in December 2008 to essentially zero, where it has remained ever since. With

policy constrained at t he zero lower bound in an economy operati ng well below full

employment and with an inflation rate remaining b elow the central ban k’stargetof

2%, first announced in January 2012, the Fed has been constrained until now to

provide desired monetary accommodation via the ‘unconventional’policies of

quantitative easing a nd forward guidance. Under several round s of quantitative

easing, the Fed purcha sed –and to this day holds –more than 4 trillion dollars’

worth of Treasury bonds and mortgage-b acked securities . Under forward guidance

as practiced by the Ber nanke Fed, the central bank conveyed that it was in no hur ry

to begin raising rates, perh aps ‘until mid-2015’–even as the unemployment rate

subsequently fell bel ow the 6.5% thresho ld that officials had i ndicated would trigger

a new assessment (as of this writing, it stands at 5.6%).

And so, with US economic growth poised to rise in 2015 toward 3%, with th e

unemployment rate exp ected to continue dec lining toward and perh aps below the

level of 5.3% cons istent with the ce ntral bank’s est imate of full employment , and

with core inflation projected to rise g radually over the next couple of yea rs toward

the inflation target of 2%, the Fed at last appe ars ready to lift off from the zero lower

bound on the Federal funds rate that has handcuffed moneta ry policy for more than

six years. Perhaps, like the great Houdin i himself, the Fed will find it a rout ine

matter to extricate it self from the shackles of the zero bou nd that has limited its

room to manoeuvre. But unlike Houdin i, who performed the feat on sta ge almost

every night for thirty years –and who often used rigged handcuffs and hidden keys –

the Fed is rusty and, to my knowledge, not in possession of a magician’s tricks!

In this essay, I discuss and assess several of th e key decisions the Fed will have to

make –and communicate –over the next sever al years as it seeks to normali ze

monetary policy in the firs t post-crisis rate -hike cycle of the 21st centur y. As I shall

94 Richard Clarida

© 2015 John Wiley & Sons Ltd