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 With unemployment steadily falling, Fed policymakers have been
waiting for a return of healthy price and wage increases. But those
have yet to appear, prompting some within the central bank to begin
doubting whether their tried and tested economic models still work.
Fed officials' private and public comments show that the debate now
centers on whether the U.S. economy is returning to its old robust
self, or whether tepid growth and resulting weak inflation and slow
wage increases have become the new norm after the deep recession of
2007-2009. The Fed's 17 policymakers are also wide apart on the
question how high interest rates should go and how quickly to get
there.
The debate will effectively determine how far U.S. rates will
diverge from those in other major economies that are still in an
easing mode and how far the dollar may rise, possibly triggering an
emerging markets sell-off and hurting U.S. exports.
Uncertainty as to who will prevail in the debate may also sow
confusion among investors, adding to market volatility.
Now even some of the hawks, who would typically worry more about
inflation risks than weak economic growth, are weighing a
possibility that they may face a long spell of sub-par growth and
low inflation. Others, such as Fed Chair Janet Yellen, have held to
a tried and true approach of trying to preempt any pick up in
prices, which they anticipate next year.
"Some of our fundamental assumptions about how U.S. monetary policy
works may have to be altered," St. Louis Fed President James
Bullard, a hawk, told a conference this month.
Reflecting such doubts, minutes from the Fed's Oct. 27-28 meeting
showed that even as they geared up for a first rate rise in a decade
several officials felt it would be prudent to plan for other ways to
stimulate the economy if low rates become entrenched.
Those in the more orthodox camp like Fed Vice Chair Stanley Fischer,
say a 5 percent unemployment, close to its long-run average, makes
them pretty confident inflation will return to the Fed's 2 percent
target, especially if oil prices stabilize.
Others worry that the U.S. economy is not behaving in a familiar way
in an increasingly complex world where weakness elsewhere threatens
to spill quickly into the United States. They advocate keeping
borrowing costs low until the Fed better understands how price
expectations are formed in the wake of the deep recession, and amid
demographic changes and technological breakthroughs.
The battle lines overlap, to an extent, with those dividing hawks
and doves in the past. They are not identical, though.
For example, William Dudley, the dovish head of the New York Fed,
and Bullard both expect inflation to rise toward target by the end
of next year, sooner than forecast by the majority of their
colleagues.
Differences in their inflation outlooks and the degree of confidence
in the predictive power of relationships between jobs, wages and
prices, are reflected in the Fed policymakers' predictions.
Their September forecasts for the central bank's key rate range from
less than zero to 3 percent by the end of next year, and from 3
percent to 4 percent in the long run.
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Yellen, Fischer and others at the Fed insist that any tightening is
likely to be gradual. Policymakers acknowledge, however, that they
have yet to agree what gradual means and this uncertainty has been
reflected in increased volatility in short-term Treasury markets in
recent months.
TRAIL OF TEARS
Fed policymakers say confidence that inflation will rebound should
be enough to pull the trigger on rates for the first time, most
likely at their Dec. 15-16 meeting. The second move may need more
proof that prices are in fact rising, so its timing will offer a
better clue to how the tightening cycle will unfold.
It may also show to what extent the Fed still relies on the theory
of an unemployment-inflation trade-off commonly known as the
Phillips curve.
"You hear arguments inside and outside the (Fed's policy) committee
that in this circumstance you should just look at inflation by
itself," Bullard, who will vote on rates next year, said. "Maybe it
is the appropriate thing to do in this environment,(but)if we are
really going to give up on the Phillips Curve at the heart of
central banking that would be a major change," he told Reuters from
his St. Louis office.
San Francisco Fed President John Williams, a Yellen ally, argues
there is a "strong case" for a December rate rise. But he has warned
that declining estimates of neutral rates - those that neither
accelerate nor slow the economy - are a "red flag" that the economy
could have become more vulnerable.
The very fact that the Fed is debating a tightening while Europe,
Japan and China continue monetary easing, is giving some
policymakers, such as Fed Governor Lael Brainard or Chicago Fed
President Charles Evans, a pause.
One fear is a repeat of what happened to the European Central Bank
and Sweden's Riksbank. Both raised rates in 2011 because of
inflation concerns only to reverse those the following year when a
nascent recovery went into reverse.
"We have had different points in time since the downturn where
certain regions of the world thought they could de-link against the
rest of the world," Evans said this month. "There's often a trail of
tears that follows that hope that their own area is stronger."
(Additional reporting by Howard Schneider and Ann Saphir; Editing by
David Chance and Tomasz Janowski)
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