Short answer: it is very unlikely that the Fed will increase the Fed funds rate this year. ... [E]arly 2012 ... is probably the earliest the Fed will raise rates - and it could be later in 2012 or even later ...Glenn Rudebusch, senior vice president and associate director of research at the Federal Reserve Bank of San Francisco, also believes it will be some time before the federal funds rate target is increased. This might be surprising because, as he notes, there are signals that the recovery is picking up:
The economic recovery has strengthened, with a self-sustaining private-sector dynamic taking hold in which increased spending leads to greater production and income and vice versa. ...
Gains in stock market wealth have helped put household balance sheets on a firmer footing. In response to rising wealth, improved sentiment, and some easing in access to credit, consumers are spending more. Auto and light truck sales in January were about 17% higher than a year ago.
Factory output has posted solid gains since the end of the recession, in part because of increasing exports. Recent orders data suggest the expansion will continue. However, ... manufacturers appear likely to retain considerable amounts of unused capacity for some time.
But while output is starting to improve, it's still a long way from returning to its pre-crisis trend, and employment is still a problem:
Nonfarm payroll employment rose only 36,000 in January, well below expectations of a 150,000 job increase. ... January ... data ... showed an overall decline in employment of 8.7 million jobs from the end of 2007 to the business cycle trough... So far in the recovery, only about 1 million of those jobs have been recovered.
The sizable amount of slack in the economy is also evident in the large output gap... Given the recent greater momentum in final sales, we have boosted our real GDP growth forecast to 4% this year and 4Â½% in 2012... However, with the economy operating far below potential, even two years of robust economic growth are not enough to attain full utilization of the nation's productive resources.
With such large output and employment gaps, inflation is still low, and no increase in inflation is expected anytime soon:
Slack in the economy has damped overall U.S. consumer inflation despite recent jumps in commodity prices. ...
By the end of next year, we expect overall and core inflation to settle at about 1%, held down in part by moderate labor costs. The rate of increase in compensation has fallen steadily since the start of the recession and is now running below 2%. With rising labor productivity, unit labor costs have actually been falling recently.
So what does this mean for the federal funds rate? Low inflation, a large output gap, and lagging employment indicate the need keep the federal funds rate at its present level for an extended period of time:
Given the extended nature of the expected recovery to levels of unemployment and inflation consistent with the Fed's mandate for full employment and price stability, the policy rule also suggests little need to raise the funds rate target anytime soon. ... Substantial monetary policy accommodation appears warranted for some time.
There's another factor that increases uncertainty about the future of the economy, and hence argues for continued monetary accommodation. Oil prices are rising, and if they continue to do so that could put a substantial drag on the recovery, especially if they remain elevated for some time. For that reason, keeping the target interest rate at its present level for an extended period of time is warranted (and I agree that there is no indication at present that the Fed intends to change the federal funds rate "anytime soon").
If oil prices do go up due to unrest in the Middle East, that will drive the prices of some goods in household budgets higher, gasoline most prominently. But in this case, rising prices are not a signal that monetary policy is too loose. The price increases are due to worries about oil supplies. Some people will try to argue for interest hikes based upon these price increases, but that would be the wrong response.
The other factor that could come into play is budget reduction. As we are seeing right now, state budgets are still in shambles largely from the effects of the recession, and there is considerable pressure to take action on the federal budget. Budget cuts at all levels of government -- which will involve loss of jobs and cutbacks in spending -- will reduce demand and slow the recovery. And if the cuts hit when oil prices are rising, the combined effect could result in a big setback for the economy. The Fed should also maintain an accommodative stance to offset, as best they can, the effects of any premature fiscal contraction.
I agree with the forecasts given above, though I'm probably more worried than they are about a wave of hawkishness coming over the Fed at the slightest hint of positive data. But my best guess it that the Fed will keep the federal funds rate at its present level through the end of the year and perhaps a bit longer. I also believe this is the correct policy. The economy has just started to recover from a very large decline, and there's still a long, long road back to full employment -- much could go wrong along the way. The need to keep the recovery going and the uncertainties ahead justify keeping interest rates low for an extended period of time.