Financial conditions in the United States have recently become less supportive of growth, with declines in broad measures of equity prices, higher borrowing rates for riskier borrowers, and a further appreciation of the dollar. These developments, if they prove persistent, could weigh on the outlook for economic activity and the labor market, although declines in longer-term interest rates and oil prices provide some offset.
Of course, economic growth could also exceed our projections for a number of reasons, including the possibility that low oil prices will boost U.S. economic growth more than we expect.
To a large extent, the low average pace of inflation last year can be traced to the earlier steep declines in oil prices and in the prices of other imported goods. And, given the recent further declines in the prices of oil and other commodities, as well as the further appreciation of the dollar, the Committee expects inflation to remain low in the near term. However, once oil and import prices stop falling, the downward pressure on domestic inflation from those sources should wane, and as the labor market strengthens further, inflation is expected to rise gradually to 2 percent over the medium term.
Yellen confirms the “gradual normalization” framework of monetary policy:
The decision in December to raise the federal funds rate reflected the Committee’s assessment that, even after a modest reduction in policy accommodation, economic activity would continue to expand at a moderate pace and labor market indicators would continue to strengthen. Although inflation was running below the Committee’s longer-run objective, the FOMC judged that much of the softness in inflation was attributable to transitory factors that are likely to abate over time, and that diminishing slack in labor and product markets would help move inflation toward 2 percent. In addition, the Committee recognized that it takes time for monetary policy actions to affect economic conditions. If the FOMC delayed the start of policy normalization for too long, it might have to tighten policy relatively abruptly in the future to keep the economy from overheating and inflation from significantly overshooting its objective. Such an abrupt tightening could increase the risk of pushing the economy into recession.
In the accompanying Monetary Policy Report presented to the Congress we read a beautiful example of circular reasoning:
Policy divergence between the U.S., where the economic recovery is strong enough to warrant a gradual tightening of monetary policy, and Europe and Japan, where downside risks are prompting central banks to boost stimulus, have pushed up the dollar. That appreciation is damping U.S. exports and thereby economic growth, and also contributing to stabilization abroad.
All else being equal, a smaller contribution to the U.S. economy from the external sector likely points to a more gradual pace of policy normalization in the United States. By the same token, the economic stimulus from more-depreciated currencies abroad may allow foreign central banks to provide less monetary accommodation — or to start removing it earlier — than would otherwise be the case.
Not for a moment does Yellen consider that it may be the tightening of Fed policy, as gleaned from the downward trend in NGDP growth which began in mid-2014, that is responsible for the price effects she alludes to!