Janet Yellen offered some more details behind her thinking on future Fed policy at a speech this evening. Here’s the key section:
Given the highly uncertain nature of the outlook, one might ask: Why not hold off raising the federal funds rate until the economy has reached full employment and inflation is actually back at 2 percent? The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial lag. If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. In addition, continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability. For these reasons, the more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data.
That’s pretty succinct. In essence, the outlier risk in Yellen’s view isn’t China, emerging markets, commodities or the dollar. She is worried that these risks will prove transitory and that the US economy will come out on the other side in a boom phase. Think of it this way. The US economy weathers the storm here, regains footing in 2016 and then as emerging markets and commodities recover we start seeing big year over year gains in inflation with the economy operating at full employment. Yellen is worried that this scenario creates a boom that the Fed is too far behind to contain.
I can’t say that I don’t see a good probability of that outcome playing out. But I am still having trouble getting too worked up over inflation when so much of the data points to disinflation and even deflation.