Taking forward the process of policy normalization, the US Federal Reserve on Wednesday raised interest rates by 25 basis points and also outlined its plan to reduce the size of its balance sheet. The US central bank expects to start shrinking its balance sheet, which expanded from the level of about $900 billion before the global financial crisis to the present level of about $4.5 trillion, later this year. The Fed is following a gradual path to normalization in order to avoid taper tantrum-like volatility in financial markets.
It will be interesting to see if the Fed will actually be able to move according to the official projection, which pencils in another rate hike this year followed by three more in 2018. Financial markets don’t think so. Policymakers at the Fed can draw comfort from the fact that the unemployment rate has come down to a low of 4.3% from about 10% in 2009. But it’s puzzling that inflation continues to undershoot the target of 2%. Therefore, the big policy question is: at what point will labour market conditions start putting pressure on prices?