There Are Going to Be Some Major Debates Inside the Fed This Week

Will the Fed Deliver an October Rate Surprise?

The author is the professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch

We probably won't learn anything new at the conclusion of this week's Federal Open Market Committee meeting, but that doesn't mean policymakers at the central bank won't have lots to debate among themselves.

To be sure, some Fed policymakers, such as Richmond Federal Reserve President Jeffrey Lacker, attempted to keep the chance of an interest rate hike at this month's meeting alive. But the reality is, the probability of an October move was greatly diminished by the most recent employment report. And, as if that wasn’t enough, evidence of a growing split within the Board of Governors itself has made an October hike all but impossible.  

So if the outcome of this particular gathering is essentially a foregone conclusion, then what will the meeting participants discuss for two days? One topic certainly to take center stage is the question of the extent, if any, of a slowdown in U.S. economic activity.

Various crosscurrents are evident in recent data. Housing, autos, and services are all generally sources of strength. In contrast, exports and manufacturing are under pressure from the impact of a slowing global economy, lower oil prices, and a stronger dollar.

The net impact is that the U.S. job market appears to have lost some momentum in recent months:

Source: Bloomberg

The U.S. economy is arguably at an inflection point, with growth set to slow in the quarters ahead.

Such an inflection point clearly complicates policymaking. The loss of momentum reduces the pace of improvement in labor markets that the Fed is looking for to ensure confidence that inflation will soon trend back toward its 2 percent target. 

But given that unemployment is already near the Fed’s estimate of the natural rate, a slower pace of growth might still be sufficient to support the central bank's current inflation forecast.

The slowdown might intensify, however, thus placing that forecast in jeopardy. Or perhaps the opposite occurs, and the economy firms. I suspect upon reviewing the data the Fed will again take the middle ground and conclude that the committee continues to see “the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring developments abroad.”

What is the proper application of risk management principles in the current situation?

This is the more significant question facing policymakers, and is where a rift grows among them. One camp is wary of having to raise rates quickly at some point in the future. This camp has essentially precommitted to its preferred path of interest rate normalization characterized by a very slow pace of rate increases. Fed Chair Janet Yellen is certainly a member of this camp.

From her September speech:

Given the highly uncertain nature of the outlook, one might ask: Why not hold off raising the federal funds rate until the economy has reached full employment and inflation is actually back at 2 percent? The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial lag. If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. In addition, continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability. For these reasons, the more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data.

For this camp, proper risk management means raising rates sooner rather than later. The sooner the Fed begins the normalization process, the lower the probability of inflation overshooting its target and thus prompting a sharp rise in rates at some later date.

An opposing camp views the risk management question very differently. It sees the policy risks as very asymmetric when policy is operating at the zero bound.

Here's Federal Reserve Governor Lael Brainard:

These risks matter more than usual because the ability to provide additional accommodation if downside risks materialize is, in practice, more constrained than the ability to remove accommodation more rapidly if upside risks materialize. The asymmetry in risk management stems from the combination of the likely low current level of the neutral real interest rate and the effective lower bound. 

Brainard argues that the downside risks associated with premature policy normalization are quite high because the Fed has limited tools to address a substantial slowing of the U.S. economy. In contrast, the Fed has very effective tools to address any realization of upside risks—it simply removes financial accommodation at a faster pace. Hence, proper risk management means delaying rate hikes until 2016. 

The extent to which Brainard and her sympathizers (notably Governor Daniel Tarullo, Chicago Federal Reserve President Charles Evans, and Minneapolis Federal Reserve President Narayana Kocherlakota) can advance their argument will influence the Fed’s reaction to any lackluster U.S. data between now and the December meeting. 

The policy response to outlying economic outcomes is fairly certain. Job growth of closer to 200,000 per month for the next two reports, confirmed by the data more broadly, will prompt the Fed to hike rates in December. Job growth of closer to 100,000 a month will likely stay the Fed’s hand, as it's consistent with a steady unemployment rate. Indeed, job growth in that range may bring to an end improvement in underemployment measures, thus raising the possibility that the Fed will need to bring more policy accommodation to the table.

The middle range of closer to 150,000 jobs a month—a more lackluster reading similar to the past two months—is the gray area. This is the range in which the proper application of risk management principles becomes critical. In that range—a range I find likely—the degree to which Brainard & Co. shape the debate at this week’s meeting will determine the policy outcome in December, and likely beyond. 

Bottom Line: The real outcome of this week’s FOMC meeting will reveal itself only indirectly through subsequent Fedspeak. If the newly awakened force of Brainard makes significant inroads among her colleagues, I would anticipate much more chatter among policymakers that, in a mediocre economic environment, the preferred risk management approach is to delay rate hikes at the expense of a faster pace of rate rises at a later time. This would also signal a broader shift in strategy, from one in which policymakers are looking for reasons to raise rates sooner rather than later to one in which they put off rate hikes until they are very confident that, once they lift off from the zero bound, they will not have to return to it. With market participants expecting only a roughly 30 percent probability of a rate hike in 2015, Brainard & Co. would become the force that again moves the Fed closer to the markets rather than vice versa.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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