Following Yellen’s path will be easy. Knowing how far to go, won’t.

Fed chair’s successor will have to tackle inflation conundrum, Joe Chidley writes.

As Federal Reserve meetings go, this week’s pretty much went according to the Janet Yellen script — which is to say, it went pretty much according to script. In raising the target rate range by 25 basis points, the Fed chair and her counterparts on the Federal Open Market Committee surprised almost nobody, in substance or in style.

Fed watchers, looking at strong economic data and low unemployment, had been expecting a hike; when it happened, currency, equity and fixed income markets shrugged it off. And in the post-announcement news conference, Yellen was her consistent self, measured and careful in her comments, interested but not altogether interesting. It was business as usual.

Except, of course, it wasn’t. Not only was this probably the last rate move under Yellen’s watch, but it was also the last FOMC announcement that would feature her making a public appearance.

By the time the next scheduled news conference rolls around, in March, Jerome Powell, President Donald Trump’s nominee to replace Yellen, will in all likelihood be sitting in her chair.

So while she will still be officially around for a few weeks, the December meeting marks the appropriate time to assess Janet Yellen’s legacy, as well as her endowment to Powell. The first seems pretty clear; the second, however, is a little harder to judge.

No doubt, Yellen is leaving the U.S. economy in far better shape than when her tenure began, in 2014. Employment growth — averaging 170,000 jobs per month from September through November — has lowered the jobless rate to a historically low 4.1 per cent. GDP growth, meanwhile, has been robust, and the Fed currently expects a solid 2.5 per cent uptick this year and next.

What’s remarkable is that those strong job and GDP numbers have been occurring even as the Fed raised its target rate five times since December 2015 and began to reduce its balance sheet, which had swelled to US$4.5 trillion in the wake of the Great Recession and quantitative easing.

Granted, rates are still low, and there is a long way to go before they return to normal (whatever that is).

But Yellen has begun the delicate process. And although the most recent FOMC dot plot, which maps out committee participants’ rate expectations, suggests three more hikes next year, nobody — least of all U.S. investors, who fuelled new highs on the S&P 500 and Dow Jones industrial average Wednesday — is freaking out.

That speaks to the judgment of the Fed under Yellen, as well as to her ability to condition market expectations even as she maintains policy flexibility.

For his part, Powell as a Fed governor since 2012 has largely followed Yellen’s lead on policy, and most observers expect him to stay the course of gradual rate hikes. Yet it is far easier to be pointed in the right direction than it is to find your precise destination. Powell as chair might find that knowing how far to go is no easy feat in the post-Yellen era.

One muddying factor can be found within the Fed’s own projections around inflation. It has remained stubbornly low throughout Yellen’s term, and the most recent data, for November, came in below expectations. The Fed didn’t change its inflation outlook from September, seeing it as staying below the two-per-cent target for the next two years. And yet it also projects GDP growth to pick up (to around 2.5 per cent for 2018 and 2019) and for unemployment to fall even lower.

How does that work, given that a tighter labour market and growing demand should create inflation? The Fed continues to wait and hope for inflation to return to two per cent, but there are no signs that it wants to. If, against the Fed’s expectations, the factors suppressing inflation turn out not to be transitory, they might derail Powell’s path to rate normalization.

There’s also the question of what normal rates look like. Yellen said on Wednesday, as she has before, that they are likely to be lower than in previous cycles. Yet given that the Fed expects GDP growth to moderate towards below two per cent post-2019, it’s easy for rate normalization to overshoot the mark, potentially tilting the economy into recession. The flattening of the yield curve suggests there is not a lot of room for getting it wrong.

On the other hand, Powell will likely have to address the inflationary impact (if any) of the Trump-backed tax cuts now being negotiated in Congress. If the Fed is right that inflation is merely waiting in the wings, fiscal stimulus in an era of full employment might bring it centre stage. True, the administration’s calculus for tax cuts and growth is optimistic in the extreme. But let’s say it delivers: the Fed will have to move more quickly than it otherwise would — raising the risk of overshooting and depleting room to manoeuvre in the event of exogenous shocks.

Finally, there’s this: by any rational measure, Yellen should still have the job. In replacing her after one term, Trump broke with nearly 40 years of presidential practice, but even worse is the fact that he had no good economic reason to do it. Ditching Yellen — the first woman ever to chair the Fed — was about politics, not policy. The danger is that Powell might continually have to fight for independence and against the perception that he’s beholden to the White House.

Put it altogether, and her successor will not have an easy job. Neither did Yellen, when she started. We can only hope that Powell is as up to the task as she has been.