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Janet Yellen must face these 5 challenges head on

Will she be Action Janet or Caretaker Janet?

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It’s barely one week into Janet Yellen’s term as Federal Reserve Chair, and few may envy her the job.

Nonetheless, all eyes will be on Yellen for the first few weeks in order to gain capital market comfort in confidently predicting her behavior.

She could turn out to be a hero, a scapegoat, or like so many past chairs, simply a store minder.

Paul Dales at Capital Economics isn’t shy about offering advice to Yellen.

(And HousingWire would like to hear from readers what advice they would offer.)

Dales has the following, summarized advice. Like the 12 labors of Hercules, here are the five challenges facing Yellen:

1. Prevent rate expectations from rising

Yellen’s immediate task is to prevent market interest rate expectations from rising as the economy strengthens, which may mean a further evolution of the Fed’s forward guidance on rates. With the unemployment rate falling to 6.6% in January from 6.7% in December, Yellen may feel the need to update the language in the policy statement that rates will be unchanged “well past the time that the unemployment rate declines below 6.5%”. If the economy continues to strengthen, as we expect, the Fed may need to try harder to anchor rate expectations. Yellen may move away from emphasizing the unemployment rate to focusing on a range of indicators. She could even steer the Fed back to stating that rates will remain at near-zero until a certain calendar date.

2. Determine how much spare capacity there is

Low rates apply only as long as the Fed believes that there is a lot of spare capacity in the economy. In this regard, two recent developments could mean that the Fed’s thinking on this issue evolves.

First, recent research by the New York Fed suggested that if it wasn’t for changes in demographics, the employment-to-population rate would have risen in recent years rather than remained broadly stable. It follows that a lot of the fall in the participation rate, that has pushed the unemployment rate lower, is due to the same demographic factors. This may mean that the lower unemployment rate is a more accurate gauge of slack than the Fed currently believes.

Second, last week the CBO revised down its estimate of the output gap, from just below -5% to just below -4%. Of course, an output gap of -4% still suggests there is plenty of room for the economy to grow rapidly without generating inflation. But this large revision highlights just how uncertain all this is. It is perfectly possible that the output gap is smaller than the Fed thinks.

Click below for the rest of Dales’ advice

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