Janet Yellen seems to be giving up on one of the Fed's most important goals

Federal Reserve Chair Janet Yellen has long been an advocate of making sure the economic recovery was translating into economic gains for Main Street before pulling back on the central bank’s support for the economy in the form of its prolonged policy of low interest rates.

But as the Fed embarks on what is only its third interest rate increase in a decade, Yellen herself appears to be leading a more hawkish charge at the Fed that is based on dubious hopes for a stronger economy under the presidency of Donald Trump as his party controls both houses of Congress.

The failure to launch of Trump and House Republicans’ new healthcare plan should offer a note of caution to Trump optimists, including those at the Fed who seem to be counting on a major boost from lower taxes and a much-touted but little-detailed infrastructure plan.

Yellen’s change of mind happened rather abruptly. In October, she touted the benefits of running the economy “a little hot,” including potentially bringing discouraged workers back into the labour force.

Yet by January, she was warning against the risks of the very same policy.

“Allowing the economy to run markedly and persistently ‘hot’ would be risky and unwise,” the Fed Chair said.

What gives? What could have changed in such a short period? The stock market’s persistent gains, and the tenuous corporate optimism that accompanied it may have something do with it. Fed officials seem to have gotten caught up in the market’s enthusiasm about the potential benefits from Trump’s policies while ignoring its potential downsides, including rising geopolitical uncertainty and the growing risk of a trade war.

The Fed’s early year enthusiasm has proved misguided before, and for several years running. Policymakers run a serious risk of making the same mistake again in 2017.

A new report from the Economic Policy Institute, a liberal think tank in Washington, suggests a Fed policy error could be even more costly than usual given the current, still-fragile state of the economy. In particular, economist Josh Bivens says the recent productivity slowdown in the US economy, is reversible as long as the economy is given room to run, rather than curbed by rate increases, as wages finally start to pick up.

“Policymakers need to keep the recovery strong until real wages begin consistently rising,” Bivens argues. “From a policy perspective this means keeping interest rates low and not prematurely raising them due to misguided fears of inflation.”

“The downside risk of reining in demand before we even test the virtuous cycle of rising wages leading to rising productivity growth is enormous,” he added.

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