Monetary Policy Risks

Glenn Rudebusch of the Federal Reserve Bank of San Francisco says something I agree with in his discussion of the outlook for the economy. His second key risk, "that we may be underestimating the effect of the past tightening of monetary conditions on the economy" due to lags between the policy and its effects is my biggest concern right now. As he notes, the federal funds rate is in the upper range of neutral. With signs of a slowdown in housing already evident, I would not object to the Fed pausing and assessing the situation thoroughly before tightening beyond 5%. In fact, I would pause at 4.75% and wait for the economy to catch up to the tightening already in the system, but with the markets fully locked in on 5%, that's presently an unlikely outcome:

FedViews, by Glenn Redebusch, FRBSF: Glenn Rudebusch, Senior Vice President and Associate Director of Research at the Federal Reserve Bank of San Francisco, states his views on the current economy and the outlook

• Corresponding charts (PDF - 63KB)
• [W]e expect ... a ... return to a fairly steady trend rate of growth this year and next as part of a robust and sustainable expansion.
• ...Going forward, we now anticipate that core inflation will remain contained.
• A risk-management strategy stresses an assessment of the range of possible alternative outcomes. At a broad level, there are probably two key risks to the forecast. First, we may be underestimating the underlying strength of aggregate demand in the economy and the impetus for higher inflation. The unemployment rate has been falling ... with no sign of a slackening in pace. More broadly, a strengthening global economy has also helped push up prices for energy and other commodities. There is a possibility that overall capacity may be strained ... So far, however, core inflation ... has remained contained.
• A second key risk is that we may be underestimating the effect of the past tightening of monetary conditions on the economy. For example, the economy, and particularly the housing sector, may be especially sensitive to the past monetary tightening already in train. ...
• There are a host of other risks to the forecast as well, including those related to the trade deficit, energy prices, the federal fiscal deficit, productivity growth, bond term premiums, and the household saving rate.
• Over the past 45 years, the real funds rate has averaged about 2-1/2 percent, which is probably close to the center of a neutral range for monetary policy. Monetary policy now appears to be positioned at the upper end of this neutral range, but the future path of policy is quite uncertain and very dependent on how the incoming data shape the outlook.

[More figures in the link to corresponding charts above]

Update: Bloomberg's John M. Berry has similar thoughts.