Dynamic concept Fiscal policy U. S.

First rate lift

In my note on February 25, 2015, I said that the Fed has formed a strategy to normalize monetary policy in the U. S. The Fed decided to adjust interest rates and not to change the size of its money in the government bond and mortgage market. At that time, the Fed was not quite sure of the time and the pace for rate lift-up.

The improvement in the labor market and the broader economy since then has suggested that the Fed is likely to raise rates in the months ahead. “The labor market is getting demonstrably closer, in my view, by almost any metric to a more normal state,” said Janet Yellen on Thursday during her testify before the Senator Banking Committee.

In general, raising rates too soon and too fast could risk threatening the economy recovery, while waiting too long would risk overheating the economy and accelerating inflation. The two risks are currently asymmetric thanks to the weak inflation in the medium term. The Fed is likely to be slow when increasing rates. “My own preference would be to be able to proceed to tighten in a prudent and gradual manner.” Yellen said on Thursday. Because the pace will be slow, the first rate liftoff is now more likely to be in September, although the difference between September and December is really negligible giving the long time lag between the time of changing monetary policy and when the policy is able to be fully transmitted to the real economy.

When the policy rate is at low bound, the dynamics of the economy is autonomous without any control as far as the interest rate is concerned. Lifting the rates will exert the control on the economic dynamics. The transition from autonomous is something like a variable-structure control problem, where a slide mode control strategy will be required in order to avoid bumps and to maintain stability. I think the Fed is exactly planning to do that by spreading the normalization process and moving the rate in a gradual way.