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Fed raises rates, but Yellen’s swan song holds a note of caution

In what was effectively her finale as head of the U.S. Federal Reserve, Janet Yellen belted out one more rendition of what has become her defining tune: an interest-rate hike. But this one sounded a little different – just enough to remind us that the Fed is heading into a new era as Ms. Yellen heads for the exit, one that will face some complications almost immediately.

The basics of the Fed's rate announcement Wednesday were pretty much par for the course: a universally expected quarter-percentage-point increase in the benchmark federal funds rate, to a range of 1.25 to 1.5 per cent, on the back of strong labour markets and solid economic growth; an encouraging outlook for the economy; the usual nagging concerns about lagging inflation.

Ms. Yellen basically gave the Fed's monetary policy one last push on the course she has set for it – a slow, steady trip to return policy to "normal," reversing the years of a highly stimulative position in the wake of the 2008-2009 financial crisis. Now she'll turn the helm over to veteran Fed board member Jerome Powell, who takes over as chairman on Feb. 3.

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(Ms. Yellen has one more rate-setting meeting, but it's on Feb. 1, which is just two days before she turns in her keys. It would be poor form to stick the new guy with a last-minute rate move on the way out the door.)

Ms. Yellen will be remembered for setting in motion the unwinding of nearly a decade of Fed policy designed to keep the U.S. economy afloat in the long, difficult recovery from the financial crisis. She has presided over five rate hikes over the past two years, lifting the key federal funds rate from a precariously low zero-to-0.25-per-cent target range to a much more comfortable 1.25 to 1.5 per cent.

This fall, she launched the Fed's "balance sheet normalization" process, which will gradually reverse the Fed's massive build-up of bond holdings under its quantitative easing programs – the big tool it wielded to revive the ailing post-crisis economy when there was no more room to slash rates.

While Ms. Yellen has laid out the game plan for monetary policy's eventual return to normal, most of the game has yet to be played. The first steps have really only occurred in the past 12 months – a period in which some pretty favourable conditions let the Fed get the normalization process off the ground with relatively few impediments. The labour market remains strong. The economy has been growing at an encouraging pace. Stock markets are at record highs. Consumer and business sentiment is high.

One of the biggest potential obstacles in the Fed's path – Donald Trump – has been much less a factor in Ms. Yellen's final year than many observers had feared. The President barely got his unorthodox economic platform off the ground.

Ms. Yellen made hay while the sun was shining, with four rate hikes and a balance-sheet normalization program since Mr. Trump's election. But as Mr. Powell prepares to take over, the clouds are gathering.

The Fed's statement accompanying Wednesday's rate hike signalled as much. While the tone was broadly positive, the Fed made an important tweak in its characterization of the labour market, a central element to Fed rate policy. It went from saying that labour markets "will strengthen somewhat further," to saying they will "remain strong."

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That might not seem like much. But it implies that with unemployment at a 17-year low, the Fed is seeing limited scope for the labour market's boom to continue. At very least, a moderation is on the way – in part because of the impact of the Fed's rate increases. While Ms. Yellen argued that it's in the Fed's best interest to keep the labour market from overheating, it nevertheless suggests it will have to be wary of the impact of further increases on sustaining full employment, which is one of the Fed's mandates.

And Mr. Powell can almost certainly count on a more complicated contribution to the economic landscape from Mr. Trump. Already, the administration's tax-cut plan has tossed a wrench into the Fed's economic assumptions; there is considerable disagreement at the Fed about just how the package will affect growth. Toss in the uncertainty surrounding the NAFTA trade negotiations, and the Fed may have to play wait-and-see on what could be some pretty disruptive policy changes in 2018.

Meanwhile, the Fed itself is undergoing a substantial reshaping. Not only is Mr. Powell taking the reins, but three of the seven spots on its board of governors are vacant. And the regular rotation of regional Fed governors on the Federal Open Market Committee will mean that four of the 12 members of that key rate-setting body will change at the Feb. 1 meeting. By the time all the changes are in place, the majority of the committee deciding on Fed rate policy will be different people.

There's no reason to think that Mr. Powell will steer Fed policy on a different course from the one Ms. Yellen has plotted. Still, there are enough changes afoot to suggest that continuing what Ms. Yellen started might prove a little more complicated.

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