The U.S. economy continues to present something of a puzzle to investors and policymakers alike. Now at or close to full employment, it should be pushing up wages and inflation. But it isn’t. This complicates the Federal Reserve’s goal of getting monetary policy back to normal.

Despite the puzzle, the Fed’s current approach – guide interest rates slowly but surely higher, and set in train a plan for reducing its balance sheet – is still correct. Deviating from this strategy before the data insist would be a big mistake.

The main thing to remember is that the current stance of monetary policy is still extremely accommodative. The short-term interest rate stands at 1.0 to 1.25 percent (negative in inflation-adjusted terms) and the Fed’s balance sheet retains some $4.5 trillion in securities purchased under the central bank’s massive program of quantitative easing. With unemployment at 4.4 percent, and asset prices sufficiently elevated to be causing the Fed some concern, that’s a very large amount of monetary stimulus.

Granted, at 1.4 percent, the Fed’s preferred measure of core inflation is below the 2 percent target, and lower than at the start of the year – but the central bank can’t afford to wait until inflation has come all the way back and is clearly on an upward trend. Monetary policy works with a lag, so acting at that point would be too late. And gently dialing back a strong monetary stimulus isn’t “tightening” in the ordinary sense. A steady intention to normalize monetary policy is still reasonable.

The Fed has insisted throughout that its approach is data-dependent, as it should be. If inflation shows signs of persistently falling, or if the good pace of job creation slackens, the Fed would be right to pause and rethink. Under those circumstances, there’d be a better case for normalizing more slowly. At the moment, there’s no such case.


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