The Federal Reserve's Monetary Policy Toolkit

The Federal Reserve could raise interest rates a second time in one year in the coming months, chair Janet Yellen said on Friday. Delivering her annual speech at the Jackson Hole economic symposium in Wyoming, Yellen said gradual increases in interest rates were “appropriate” and the case for another had “strengthened”.

The Federal Open Market Committee (FOMC), the policy-setting branch of the Fed, has met five times this year; each time, its members voted to hold off on raising interest rates. Minutes from the most recent meeting revealed concern over Britain's vote to leave the European Union and a potential slowdown in job creation. “Several long-term global risks related to Brexit remained."

Interest Rates

In Jackson Hole, Yellen noted that in the absence of hikes, interest rates have remained historically low, which could hinder the Fed’s ability to fight recession in the near future. By lowering interest rates, the Fed provides an incentive for businesses and consumers to take out loans and to spend money, thus fueling the economy. But as interest rates are already low, the Fed may not be able to lower them as far as it might have in the past.

Economic Outlook

 U.S. economic activity continues to expand, led by solid growth in household spending. But business investment remains soft and subdued foreign demand and the appreciation of the dollar since mid-2014 continue to restrain exports. While economic growth has not been rapid, it has been sufficient to generate further improvement in the labor market. 

The FOMC continues to anticipate that gradual increases in the federal funds rate will be appropriate over time to achieve and sustain employment and inflation near our statutory objectives. Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, the case for an increase in the federal funds rate has strengthened in recent months. Of course, the decisions always depend on the degree to which incoming data continues to confirm the Committee's outlook.

As ever, the economic outlook is uncertain, and so monetary policy is not on a preset course. The ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances may buffet the economy. In addition, the level of short-term interest rates consistent with the dual mandate varies over time in response to shifts in underlying economic conditions that are often evident only in hindsight.

Conclusion

Although fiscal policies and structural reforms can play an important role in strengthening the U.S. economy, Yellen's primary message today is that she expect monetary policy will continue to play a vital part in promoting a stable and healthy economy. New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns. Additional tools may be needed and will be the subject of research and debate. But even if average interest rates remain lower than in the past, she believe that monetary policy will, under most conditions, be able to respond effectively.

Yellen ended by saying that despite historically low interest rates, “monetary policy will, under most conditions, be able to respond effectively.”