The Fed: Invasion of the Inflation Doves

Picture the horror-movie scene in which the terrified family barricades the door to keep the murderer out, only to discover he's already inside. Federal Reserve Governor Kevin M. Warsh evoked that scary image in a speech on Mar. 26 to describe the threat to inflation-fighting central bankers from economists who are, in his view, insufficiently hawkish on inflation. Said Warsh: "Not all of the threats to central bank independence come from outside the walls of the Federal Reserve. Some pressures, however well-intentioned, like in the clichéd scary movie, may come from inside the house."

Emotions must be running high when bland central bankers start casting disagreements over interest-rate policy in terms that are more familiar to fans of Freddy Krueger. The charged language may be further evidence of a growing divide between hawks and doves over how strenuously the Federal Reserve should fight inflation. This isn't a drawing-room debate. The outlook for growth and inflation depends on how quickly the Fed rolls back the emergency monetary easing it put in place to combat the worst economic downturn since the Great Depression.

Until now, the rate-setting Federal Open Market Committee has been remarkably unified under Chairman Ben Bernanke. Even the committee's inflation-phobic hawks have mostly gone along with lowering the federal funds target rate to a basement-floor zero to 0.25% and flooding the banking system with excess reserves to encourage lending.

But the hawks' grumbling is getting louder. Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City, broke ranks at meetings in January and March, dissenting from the FOMC's determination to keep the federal funds rate at "exceptionally low levels" for "an extended period." Hoenig loses his FOMC vote next year, but two other hawkish regional bank presidents are scheduled to become voting members of the FOMC: Richard W. Fisher of Dallas and Charles I. Plosser of Philadelphia.

Monetary hawks argue that over the long run, very low and predictable inflation is the best condition for growth. In his Mar. 26 speech, Warsh attacked an idea that particularly frightens the hawks: a proposal that central banks should try to make inflation rise a bit to a long-term average of around 4%. (Inflation in personal consumption expenses, excluding food and energy, is all of 1.3% over the past year.) The 4% idea was raised on Feb. 12 in a widely noted paper by Olivier Blanchard, research director of the International Monetary Fund. Blanchard suggested that higher average inflation would make it easier for central banks to stimulate growth in a recession by cutting interest rates. The idea is that cutting borrowing costs to below the inflation rate encourages expansion by effectively paying people to take out loans. Thus, cutting interest rates to zero can be more stimulative when inflation is 4% than when it's just 2%. That's a dangerous idea, Warsh said. "Central banks that desire just a little more inflation may well end up with a lot more."

Here's where the horror-movie plot thickens. Blanchard, as a pillar of the economics Establishment, may well have been the threat "from inside the house" to whom Warsh was referring. Then again, Warsh may have meant a true Fed insider, John C. Williams, research director of the San Francisco Fed, who wrote a paper similar to Blanchard's last September. But Williams isn't quite the foe hawks might imagine. In an interview on Mar. 29, he said he understands Warsh's misgivings. He added that while there are theoretical advantages to a 4% inflation target, the risks of confusing the market by moving to a higher target now might be unacceptably great.

Confused yet? Don't worry. The main plot line is still hawks vs. doves. And as the U.S. economy recovers haltingly, that fight isn't going away.

    Before it's here, it's on the Bloomberg Terminal.