Fed Officials Push Financial Stability to Center of Rate Debateby
Inflation takes backseat with mute projected price pressures
Evans says anchored rate expectations to limit financial risk
With U.S. inflation low and seen staying that way, Federal Reserve officials who favor raising interest rates point to preserving financial stability as another reason to move. Chicago Fed President Charles Evans, a key advocate of delaying action, is making a new argument to push back against that notion.
His comments in Beijing earlier on Wednesday touch on key questions for the policy-setting Federal Open Market Committee when it meets next month: Do officials need to increase rates before inflation rises to their 2 percent target, in order to avoid the need for faster tightening later on and to keep financial risks at bay? Or should they let inflation reach their goal first to make sure it gets there and stays there?
Remarks by Fed Chair Janet Yellen in Jackson Hole, Wyoming, on Aug. 26 are “consistent with the former” view, said Michael Gapen, chief U.S. economist at Barclays in New York. “There is a group within the Board that is consistent with the latter, and I think Charlie is part of that group.”
The Fed’s preferred inflation gauge has been below the target for more than four years and Fed staff project it will still be slightly below 2 percent in 2018.
Minutes of the FOMC’s July meeting showed that several officials had argued the Fed “would likely have ample time to react if inflation rose more quickly than they currently anticipated,” while several also voiced concern that keeping rates low for longer “risked intensifying incentives for investors to reach for yield and could lead to the misallocation of capital and mispricing of risk.”
“The core of the committee is behaving as though they are willing to risk overshooting here, and Evans has been at the forefront,” said Ethan Harris, global head of economics research at Bank of America in New York. “The Fed has been already making this compromise for years now: that we know that zero-rate policies can create very aggressive behavior in the markets, and so we need to keep an eye on that, but we’re willing to do it anyway.”
Boston Fed President Eric Rosengren, who spoke at the same conference in Beijing, flagged elevated valuations in commercial real estate as a potential risk, arguing that the Fed should continue raising rates soon to ensure it could tighten slowly. The desire is to avoid a repeat of what happened in 2013, when the Fed signaled a shift in its policy stance by discussing the tapering of asset purchases, triggering an unsettling surge in yields.
Evans, at the same conference, said the prospect of a faster pace of tightening later on, in the event that the Fed forgoes rate increases until inflation has reached 2 percent, shouldn’t present such concern.
He cited recent conversations with life-insurance industry executives who told him that subdued expectations for interest rates over the longer run are “being built into business plans,” which implies that “lower policy rate expectations act as a restraint on how much long-term rates could rise following a surprise over the near-term policy path.”
The yield on 10-year U.S. Treasury notes has fallen about nine-tenths of a percentage point since June 2015. A survey of big hedge funds and asset managers conducted by the New York Fed supports Evans’s thesis: The results suggest a lower expected path of the Fed’s policy rate over the next 10 years accounts for most of the decline in yields.
Still, Evans’s argument may not be enough to sway his colleagues on the FOMC who worry about a repeat of the asset-price crashes that triggered the last two U.S. recessions, Gapen said, referring to the 2007-2008 housing collapse, and the technology bubble that burst in early 2000.
“The last two cycles should give us enough evidence that we are incapable of seeing the development of these risks in real time,” he said. "A better procedure is to do something -- go a little bit slower, and not just be full-steam.”