Stanley Fischer and Lael Brainard Are Battling for Yellen’s Soul

Inflationary risks vs. financial market turmoil.

Inflation Limits Fed's Ability to Do More: Zentner

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.

Federal Reserve Vice Chairman Stanley Fischer sits on Chair Janet Yellen’s left shoulder, muttering:

… we may well at present be seeing the first stirrings of an increase in the inflation rate …

Fed Governor Lael Brainard perches on the right, whispering:

… there are risks around this baseline forecast, the most prominent of which lie to the downside.

Yellen is caught in a tug of war between Fischer and Brainard. At stake is the Fed chair’s willingness to embrace a policy stance that accepts the risk that inflation will overshoot the U.S. central bank’s target. At the moment, Brainard has the upper hand in this battle. And she has a new weapon on her side: increasing concerns about the stability of inflation expectations.

The lines of division within the Fed are clearly drawn. One side fears the inflationary consequences of a labor market quickly nearing full employment and below.

Here’s Fischer in February:

… a persistent large overshoot of our employment mandate would risk an undesirable rise in inflation that might require a relatively abrupt policy tightening, which could inadvertently push the economy into recession. Monetary policy should aim to avoid such risks and keep the expansion on a sustainable track.

This side believes that overheating is the greatest risk to the expansion, and hence the state of the labor market warrants preventive medicine in the form of early interest rate hikes. Such concerns are only aggravated by the recent uptick in inflation. In addition, the residents of this camp tend to be dismissive of the negative implications of recent financial market turmoil.

Fischer’s not alone. In his group sit Federal Reserve Bank of San Francisco President John Williams, Kansas City Fed President Esther George, and Cleveland Fed President Loretta Mester. And Yellen is believed to be reasonably sympathetic to this camp. She’s repeatedly voiced her support of a Phillips curve view of the world—or the idea that, after accounting for the temporary impacts of a strong U.S. dollar and weak oil, inflation will rise as unemployment rates fall. As the economy reaches full employment, inflation should trend toward the level consistent with longer-run inflation expectations. Her faith in this model became a justification to raise rates early so they could be raised slowly.

Indeed, a Phillips curve view is fairly common among monetary policymakers. Even Brainard concurs. From her recent speech:

Over the next couple of years, there are reasons to expect energy prices and the dollar to eventually stabilize, output to increase at around the moderate pace it has averaged over the recovery thus far, foreign growth to recover somewhat, the U.S. labor market to improve further, and inflation to move toward our 2 percent target.

So, given the Phillips curve framework’s consistency among policymakers, why delay further rate hikes? After all, the labor market appears poised to deliver still-lower unemployment rates in the months ahead, a growing body of evidence points to accelerating wage growth, and even core-PCE inflation—the central bank’s preferred measure—has picked up in recent months. In other words, it seems like the Fed’s plan is coming together.

The challenge for further rate hikes is that recent financial instability has exposed the downside risks to the forecast.

This has been a prominent concern among policymakers who prefer a cautious approach to further rate hikes. Here’s Brainard again:

Given weak and decelerating foreign demand, it is critical to carefully protect and preserve the progress we have made here at home through prudent adjustments to the policy path. Tighter financial conditions and softer inflation expectations may pose risks to the downside for inflation and domestic activity. From a risk-management perspective, this argues for patience as the outlook becomes clearer.

New York Fed President William Dudley, Philadelphia Fed President Patrick Harker, and Boston Fed President Eric Rosengren have all expressed similar sentiments.

Financial instability certainly gives the Fed reason to stand still this week. And it gives reason for the Fed to continue to be cautious. Last October, Brainard began building the case that international spillovers from tighter U.S. monetary policy limit the extent to which the Fed can raise rates. In short, the globalization of finance leaves the central bank unable to fully resist the pull of zero or lower interest rates across Japan and Europe.

But Brainard & Co. are crafting another position to sway Yellen into the dovish camp—one that leverages the chair’s existing sympathy for Fischer and his Phillips curve view. The twist is that Brainard and her allies are shifting focus away from “resource utilization” toward “inflation expectations.” Anchored inflation expectations are an integral part of the Phillips curve story as they provide the central tendency for inflation over time.

Recall Yellen from September

Although the evidence, on balance, suggests that inflation expectations are well-anchored at present, policymakers would be unwise to take this situation for granted. Anchored inflation expectations were not won easily or quickly: Experience suggests that it takes many years of carefully conducted monetary policy to alter what households and firms perceive to be inflation’s “normal” behavior, and, furthermore, that a persistent failure to keep inflation under control—by letting it drift either too high or too low for too long—could cause expectations to once again become unmoored.

Brainard argues that inflation expectations may not be all that well-anchored:

Moreover, measures of inflation compensation and some survey-based measures of inflation expectations suggest that inflation expectations may have edged lower. Given the currently weak relationship between economic slack and inflation and the persistent, depressing effects of energy price declines and exchange rate increases, we should be cautious in assessing that a tightening labor market will soon move inflation back to 2 percent.

Likewise, her ally Dudley challenges the contention that inflation expectations are stable:

This continued period of low headline inflation is a concern, in part, because it could lead to significantly lower inflation expectations. If this drop in inflation expectations were to occur, it would, in turn, tend to depress future inflation. Evidence on the inflation expectations front suggests some cause for concern … these developments merit close scrutiny, as past experience shows that it is difficult to push inflation back up to the central bank’s objective if inflation expectations fall meaningfully below that objective. Japan’s experience is cautionary in this regard.

Both Rosengren and St. Louis Fed President James Bullard have voiced similar concerns. The combination of flagging survey-based measures of inflation expectations and collapsing market-based measures of inflation compensation are sapping confidence that the pace of normalization can continue at the rate envisioned in December. I suspect Yellen will find this a persuasive argument, as it goes to the heart of the Phillips curve model.

Bloomberg

Where does that leave us as we head into the March meeting?

The Fed is widely expected to leave rates unchanged, and they will do as predicted in this regard. The economic forecasts will likely remain fairly unchanged while the interest rate forecasts (better known as the dot plot) will move down to indicate they anticipate at most three more 25-basis-point rate hikes this year, down from four in December. Once again the Fed will shift toward market expectations, rather than vice versa.

More important is how the Federal Open Market Committee balances labor market strength and the generally solid economic data we’ve seen out of the U.S. recently, against financial volatility and declining inflation expectations. The outcome will indicate the hurdle for future rate hikes. A focus on the latter factors indicates increasing caution, and with it a willingness to embrace the risk that the Fed falls behind the inflation curve. They leave open the option for a hike in April or June but say nothing that suggests a commitment to such a move. A focus on the former suggests it’s full steam ahead; the start of the year was just a hiccup in the Fed’s plans, nothing more.

I expect it’s unlikely the Fed will send a “full steam ahead” signal, for the following reasons:

  1. Although data have generally been solid, it’s too early to expect to see the impact of recent tightening. Hence, policy needs to remain cautious.
  2. The belief that the Fed policy can diverge significantly from the rest of the world has been called into question.
  3. Recent stability in financial markets is a hopeful sign that we have seen the worse, but it’s too early to proclaim us out of the woods. Corporate bond markets, for instance, remain considerably tight.
  4. A wide range of policymakers have expressed the view that risks are tilted to the downside and/or inflation expectations are softening.

The most hawkish message I could foresee is that the “balance of risks” language returns with a balanced outlook. This seems unlikely given the above four points, so I tend to think that disagreement among FOMC participants leads them to decline to assess the balance of risks once again. A more dovish position would be to weigh the balance of risks to the downside, but that would send an easing signal. I don’t think even Brainard & Co. are there quite yet. Look also for increased concern about deteriorating inflation expectations. That would be a sure sign of a dovish mood within the Fed.

Bottom Line: This meeting is likely to expose sharp differences among FOMC participants. One side, personified by Fischer, has an innate desire to dismiss financial market turmoil and instead focus on the inflationary implications of labor market strength. The other side, personified by Brainard, focuses on the downside risks implied by financial turmoil and deteriorating inflation expectations. Yellen is caught between the two.