An increase in interest rates will likely be justified this year, Federal Reserve chairwoman Janet Yellen said Thursday.
In text prepared for a speech at University of Massachusetts Thursday afternoon, the head of the U.S. central bank indicated that she still believes that the Fed will raise rates in 2015, despite declining to do so in its most recent monetary policy meeting last week.
Yellen stated that “my colleagues and I anticipate that it will likely be appropriate to raise” the Fed’s short-term interest rate target “sometime later this year and to continue boosting short-term rates at a gradual pace thereafter.”
The Fed declined to raise rates at its September meeting on the grounds that slower growth in China and elsewhere overseas could blunt U.S. growth and prevent inflation from rising to the Fed’s 2 percent target.
Yellen said Thursday, however, that she expected inflation to rise as the “temporary factors” holding down inflation in recent months waned and economic growth picks up.
Yellen delivered her speech as the Fed’s policy of maintaining short-term interest rates near zero stretches on toward its seventh year. With the economy now several years away from the crisis that prompted such an extraordinary monetary response, some members of the Fed have questioned why the central bank has not raised its interest rate target.
At the same time, inflation in recent months has been closer to zero than to the Fed’s 2 percent target, a gap that has led other Fed officials to suggest that tightening monetary policy now would be too early.
In a 5,500 word academic speech reviewing historical inflation trends and economists’ views on the causes of inflation, Yellen laid out the case for raising rates soon.
With the economy growing and public inflation expectations stable, Yellen explained, theory and evidence suggest that inflation will rise once temporary factors abate. Those temporary downard pressures on prices include falling oil prices and the recent appreciation of the dollar.
Nevertheless, Yellen acknowledged that “economists’ understanding of the dynamics of inflation is far from perfect.” She specifically referenced the example of Japan, which saw persisent deflation over the course of the late 1990s and early 2000s even as inflation expectations remained stable — a combination that defied the predictions of the models employed by the Fed.
Another uncertainty is that the Fed has only a limited ability to gauge the strength of underlying economic growth, Yellen noted, and to assess the threat to the recovery posed by slowing growth overseas, among other possible economic “headwinds.”
Even with those notes of caution, Yellen said, the Fed has to act sooner rather than later because “monetary policy affects real activity and inflation with a substantial lag.”
In other words, if the Fed waits for positive confirmation that inflation is rising toward its goal, it would face the possibility that inflation would then rise out of its control, forcing them to hike rates hurriedly, potentially choking off growth.
Before Thursday’s speech, many investors had expected the Fed to wait until 2016 before raising rates. Futures markets on Thursday suggested that investors on balance did not expect a first rate hike until the Fed’s monetary policy meeting in March.
