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Regardless of what happens in Washington, D.C. regarding the debt limit and tax policy, the January 30 Federal Reserve meeting will give us a few guideposts on what to expect for the economy in 2013.

The good news is that economic indicators showed continued improvement, highlighted by very good news from the housing market -- new housing starts had their best year since 2008. An anemic housing and labor market were identified as the main drags on the economy since the end of the recession, and it seems we have turned another corner.

Since every major economic recovery in the past century has been fueled by growth in residential investment, these improved conditions are a good leading indication of accelerated GDP growth for the coming year. In the meantime, the inflation rate shows continued moderation with virtually no change in the CPI in December. The year-to-year core inflation rate has been under 2%. And job creation is still quite modest, but the unemployment rate appears to have stabilized and is expected to continue its downward trend.

What should the Fed do? In the second part of 2012, the Federal Reserve implemented three policy actions in support of continued accommodation. First, it announced an open-ended "QE3" policy of purchasing $40 billion dollars of additional mortgage backed securities per month. Second, it extended the Operation Twist initiative of increasing the average maturity of its Treasury securities holdings. Third, rather than specify an estimated time period for the Fed to maintain an "exceptionally low" Federal Funds rate (e.g., through mid-2014), the language in the December 12th FOMC statement now ties these low rates to an explicit unemployment rate (above 6.5%) for the first time.

Some have criticized this change of language, citing how difficult it has been historically for the Fed to target the unemployment rate while maintaining price stability. To be fair, the statement also ties its low interest rate policy to an inflation rate of no more than 2.5% and anchored inflation expectations. With impeccable timing, the Fed accommodation policies have seized the momentum in the housing market, thus setting the economy up for continued economic growth into 2013.

But such accommodations are not without their dangers. Explicitly noting an unemployment rate target in such a manner may mitigate the Fed's desire for transparency. For example, they do not state a contingency plan should they be unable to simultaneously target both low unemployment and inflation at the same time. But trying to do so may force them to abandon their inflation targets without being able to lower unemployment significantly.

Such a scenario may significantly elevate inflation expectations and lead us back to the failed monetary policies of four decades ago. Properly navigating these policy pitfalls and having an appropriate exit strategy becomes ever more important over the next year as the Fed continues to guide the economy from the worst recession since the Great Depression.

Source: The Challenges Ahead For The Federal Reserve And Economy In 2013