Early rate rises not in Fed’s Plan A

The Federal Reserve is likely to indicate some increased concern about inflation following its policy meeting this week, but to do so in a manner than avoids any suggestion that interest rate rises are imminent.

Indeed, it may not say that it now sees the risk to inflation as greater than the risk to growth. If it does, it will probably qualify the assessment either by stating that the risks remain quite closely balanced, or by emphasising economic uncertainty. Interest rates will stay on hold at 2 per cent.

The US central bank is trying to walk a fine line. It wants to convince investors and the public it will do whatever it takes to stop high rates of inflation – pushed up by oil and food prices – becoming entrenched in inflation expectations.

But it also wants to avoid an excessive run-up in market interest rate expectations, since that would push up the actual cost of loans unduly, putting pressure on a still-fragile economy.

Larry Meyer, a former Fed governor, says recent hawkish talk by Fed officials represents a “conditional commitment” to raise rates if the sources of inflation risk deteriorate. But he says the market has difficulty distinguishing this from an “unconditional signal that policy tightening is imminent”.

By the start of last week the market was pricing in three or four rate rises this year. Investors scaled back these bets following reports in the Financial Times and other newspapers that policymakers did not expect to raise rates so quickly.

Senior officials appear to think in terms of a base case for rate increases and a risk case. The base case may have some tightening this year – but probably at most one or two increases by year end. The logic here is that interest rates at 2 per cent, while accommodative, are not wildly stimulative owing to persistent financial stress. This may be about right, given the weak growth forecast and remaining downside risks – highlighted by the decline in bank stocks, which are now trading below their March lows.

This suggests no need to raise rates rapidly. However, it would still be necessary to raise rates in a calibrated manner as the economic outlook improved and financial stress moderated, easing overall financial conditions.

But these officials also appear to think of a risk case in which they would have to raise rates sooner and faster to contain inflation.

Ben Bernanke, Fed chairman, outlined the main triggers for the more rapid rate increase scenario in a speech on June 9. He promised to pay “close attention” to “the pass-through of high raw materials costs to the prices of most other products and to domestic labour costs”. And he stressed that the central bank would “strongly resist an erosion of longer-term inflation expectations”.

The Fed – in its economic forecasts – has indicated its desire to take an extended period to bring inflation back to more normal levels following the oil shock, in order to moderate the cost in lost output and employment, particularly given the simultaneous shock from the credit crisis.

Mark Gertler, a professor at New York University, says the rise in oil prices “cannot continue indefinitely” and, when it ceases, headline inflation should fairly quickly fall to the lower core rate that excludes food and energy.

But as Don Kohn, Fed vice-chairman, emphasised in a speech on June 11, the central bank’s ability to tolerate above-normal inflation for a while is “tempered” by the need to ensure inflation expectations remain broadly stable during the period of fast-rising prices. This is the crux of the internal Fed debate.

Most Fed officials think that inflation expectations remain under control – at the high end of their normal range. They are not inclined to move rates simply in response to an uptick in a University of Michigan survey.

But that made them uneasy, and while they draw some comfort from the relative stability of market-based inflation expectations, these are in some sense premised on market rate expectations.

Now that the likelihood of a severe recession has declined, Fed hawks would like to raise rates relatively quickly and pre-emptively to lock down expectations. In effect, that would make the risk case strategy the base case.

“Credibility is much easier to keep than it is to recover,” James Bullard, president of the St Louis Fed, said on June 11.

Senior officials, though, believe that with unemployment at 5.5 per cent and moving higher there should be enough economic slack to ensure commodity price pressures do not infect inflation expectations and ignite domestic inflation.

They appear to be signalling that early, rapid rate rises are not in Plan A – but there is a more aggressive Plan B, and they will switch to it if challenged.