By Greg Ip

The stock market's postelection euphoria got a reality check Wednesday when the Federal Reserve raised interest rates and gently hinted more are in store, in particular if the economy gets a dose of fiscal stimulus.

So is the central bank on a collision course with incoming President Donald Trump? Probably not.

For at least the next year or two, the interests of Mr. Trump and Fed Chairwoman Janet Yellen are closely aligned. He wants low unemployment and faster economic growth, and she's happy to err on the side of both via the most docile course of interest-rate increases on record, so long as inflation stays low.

Historically, tensions arose between presidents and Fed chairmen as the former wanted low unemploymentat any cost, and the latter prioritized low inflation. Today is different. Inflation has persistently been below the Fed's 2% target, and the Fed believes structural changes in the economy mean it can't tolerate a federal-funds rate -- what banks charge each other for overnight loans -- much above 3%. These two factors are a powerful incentive for Mrs. Yellen to err on the side of easy monetary policy.

Mrs. Yellen is a firm believer in the Phillips curve, which holds that if unemployment falls below some natural rate, the scarcity of labor and other resources pushes wages and prices higher. Fed officials put that natural rate at 4.8%. In November, actual unemployment dropped below that level, to 4.6%.

Yet officials see the jobless rate averaging even less, at 4.5%, for the next three years. "We think that's appropriate because we want inflation to rise to our 2% objective in a timely fashion," she told reporters after Wednesday's meeting of the Fed's policy-making panel.

November's unexpected drop in unemployment is one reason several Fed officials penciled in three rate increases next year, instead of two, according to projections released after the meeting. Those rate revisions, in turn, sent stocks lower and bond yields higher on Wednesday.

Yet the actual changes were trivial. Averaging all officials' forecasts, the Fed's target for overnight funds is seen rising to 1.37% by the end of next year, up only marginally from 1.31% in September. A more revealing comparison is to the forecasts for the end of the year given in March, when the projected average was 2.04%. So despite a job market that continues to perform solidly, officials are sticking to the "new normal" view of interest rates: much lower than they have been historically, for much longer.

In this world, the Fed tends to see bad news as a reason to delay tightening without using good news as areason to speed up. A few officials think the prospects of Mr. Trump ushering in a big deficit-financed tax cut and spending boost merit an extra rate increase next year, Mrs. Yellen said, but she doesn't appear to be one of them; she would prefer to see the details.

The Fed chairwoman is also inclined to let the unemployment rate test its lower bounds. In October, she speculated that letting unemployment run persistently below its natural rate might pull some discouraged workers back into the labor force. On Wednesday, she emphasized she wouldn't allow such an experiment to push inflation above the Fed's target.

Since then-President Bill Clinton adopted the policy of not publicly criticizing the Fed, its chairmen have been largely free to set policy without worrying about what the White House would say. But the days when central bankers stood above the political fray are now over. During the campaign, Mr. Trump accused Mrs. Yellen of holding down rates to help President Barack Obama, and included her in a television ad attacking multinational bankers.

Many of his advisers fret that central banks' stimulative policies, from bond buying to zero or negative interest rates, have done more harm than good. "If we woke up tomorrow and every central bank in the world raised interest rates by 300 basis points, the world would be a better place," Goldman Sachs executive Gary Cohn, soon to become director of Mr. Trump's National Economic Council, said this year.

But those objections may make little practical difference for the next few years since the Fed is moving away from zero anyway.

And just as Mr. Trump's campaign attacks on Mr. Obama didn't prevent the two from developing a rapport after the election, his administration's relationship with Mrs. Yellen likely will depend more on her performance than her political party.

Mr. Cohn, after all, is a Democrat. Steven Mnuchin, Mr. Trump's pick for Treasury secretary, has said Mrs. Yellen has done a "good job." Though Mr. Trump has said he'd likely name a Republican when her term expires in early 2018, it is too soon to write off the possibility of reappointment.

Mrs. Yellen declined to speculate on her future, while reminding reporters her term doesn't coincide with the president's for a good reason: it makes it easier to act without fear of political interference. The implicit message is she plans to do what she has to whether Mr. Trump likes it or not. So far, though, there is not a lot to dislike.

Write to Greg Ip at greg.ip@wsj.com

(END) Dow Jones Newswires

December 14, 2016 19:28 ET (00:28 GMT)

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