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

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 unemployment 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 persistent excess of global saving relative to desired investment opportunities, 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%.