Fed­eral Re­serve’s pa­tient or pre­emp­tive clash looms as in­fla­tion fails to hit goal

Business World - - BANKING & FINANCE -

FOR­MER Fed­eral Re­serve Chair­man Alan Greenspan, in year nine of a US eco­nomic ex­pan­sion, con­ceded in 1999 that pa­tience was some­times a bet­ter pol­icy than his doc­trine of pre­emp­tive in­ter­est-rate moves be­cause “the fu­ture at times can be too opaque to pen­e­trate.”

For some Fed of­fi­cials, th­ese days look like one of those times to wait for clar­ity.

Faith in pre­emp­tion — the Greenspan- era strat­egy of set­ting of mon­e­tary pol­icy based on fore­casts to get ahead of where the econ­omy was go­ing — is be­gin­ning to fal­ter among some of­fi­cials. That’s be­cause in the cur­rent ex­pan­sion’s ninth year, in­fla­tion isn’t ac­cel­er­at­ing as they pre­dicted for rea­sons that aren’t yet un­der­stood, even as the la­bor mar­ket tight­ens and global growth im­proves.

“The con­ven­tional wis­dom did not work in the 1990s and it is not work­ing now,” said Allen Si­nai, chief ex­ec­u­tive of­fi­cer of De­ci­sion Economics in New York.

The de­bate over whether the Fed should get ahead of the in­fla­tion curve or stick with a wai­t­and-see ap­proach is heat­ing up ahead of the Fed­eral Open Mar­ket Com­mit­tee’s meet­ing next week. In­flu­en­tial pol­icy mak­ers such as Gover­nor Lael Brainard and New York Fed Pres­i­dent Wil­liam Dud­ley have staked out dif­fer­ent views about whether to let the job mar­ket run hot­ter or rely on once-trusted mod­els and cool it down pre­emp­tively.


Of­fi­cials are ex­pected to keep rates on hold while an­nounc­ing the start of a grad­ual process to shrink their $4.5 tril­lion bal­ance sheet. Still, the dis­cus­sion about why in­fla­tion has been stuck un­der their 2% tar­get for most of the past five years could sharpen be­tween hawks push­ing for an­other hike this year and doves pre­fer­ring to de­lay.

Out­size de­clines in the prices of things like cell phone plans, doc­tor vis­its, new ve­hi­cles and ho­tel rooms have con­trib­uted to a broader de­cel­er­a­tion in US in­fla­tion over the past five months de­spite low US un­em­ploy­ment.

That has led key pol­icy mak­ers not only to ques­tion whether the la­bor mar­ket still has more room to run be­fore trig­ger­ing ex­ces­sive in­fla­tion, but also whether they should still be tak­ing a pre­emp­tive ap­proach to ward­ing it off at all — a view at the core of mod­ern cen­tral banking.

The com­ing months should be re­veal­ing, ac­cord­ing to Dud­ley, who said on Sept. 7 that technology-en­abled changes in how con­sumers shop may be weak­en­ing busi­ness pric­ing power and weigh­ing on in­fla­tion.


“We just don’t know at this point whether the in­fla­tion de­cline that we’ve seen is mostly be­ing driven by tran­sient, idio­syn­cratic fac­tors, or whether it’s some­thing more sec­u­lar, longer-term at play,” Dud­ley said. “My view is the jury’s out, and I think the data over the next six months is go­ing to be very, very im­por­tant.”

Either way, the New York Fed chief be­lieves of­fi­cials should still be able to count on the so-called Phillips curve — named for the late econ­o­mist Wil­liam Phillips, whose 1958 dis­cov­ery of a his­tor­i­cal re­la­tion­ship be­tween un­em­ploy­ment and wage growth in the UK guided gen­er­a­tions of cen­tral bankers.

To Dud­ley’s mind, the ques­tion is whether struc­tural changes have led to a sit­u­a­tion in which in­fla­tion is lower for any given level of la­bor uti­liza­tion.

If so, it would im­ply that the Fed can de­lay fur­ther rate hikes un­til un­em­ploy­ment falls fur­ther, but that it will even­tu­ally need to re­sume pre­emp­tive tight­en­ing to ward off in­fla­tion as it rises to­ward 2%.

“I’m not ready to throw the Phillips curve out the win­dow, but I am will­ing to be a lit­tle bit ag­nos­tic about whether full em­ploy­ment is po­ten­tially as high as we think it is,” he said.

Brainard has less faith that in­fla­tion will even­tu­ally rise back to the tar­get if the un­em­ploy­ment rate goes low enough. Part of the doubt is due to low in­fla­tion ex­pec­ta­tions, which may rep­re­sent the un­der­ly­ing, trend level of in­fla­tion.

“Some might de­ter­mine that pre­emp­tive tight­en­ing is ap­pro­pri­ate on the grounds that mon­e­tary pol­icy op­er­ates with long lags, and in­fla­tion will inevitably ac­cel­er­ate as the la­bor mar­ket con­tin­ues to tighten be­cause of the Phillips curve,” she said Sept. 5. “How­ever, in to­day’s econ­omy, there are rea­sons to worry that the Phillips curve will not prove very re­li­able in boost­ing in­fla­tion as re­source uti­liza­tion tight­ens.”


Prospects for fis­cal stim­u­lus af­ter Repub­li­cans won the US pres­i­den­tial elec­tion in Novem­ber ap­peared to raise ex­pec­ta­tions for in­fla­tion among in­vestors, but the ef­fect has faded over the past six months amid a re­turn to po­lit­i­cal grid­lock in Wash­ing­ton.

“The key ques­tion in my mind is how to achieve an im­prove­ment in longer-run in­fla­tion ex­pec­ta­tions to a level that will al­low us to achieve our in­fla­tion ob­jec­tive,” Brainard said. “I be­lieve it is im­por­tant to be clear that we would be com­fort­able with in­fla­tion mov­ing mod­estly above our tar­get for a time.”

A year ago, when con­cerns about global growth loomed over fi­nan­cial mar­kets, there was more dis­cus­sion among pol­icy mak­ers about al­low­ing in­fla­tion to rise above their 2% tar­get.

That may be a tougher sell to­day, said Neil Dutta, head of US economics at Re­nais­sance Macro in New York.

“It seems as though the rest of the com­mit­tee sees weak in­fla­tion as be­ing largely a func­tion of fac­tors un­likely to per­sist,” Dutta said. “With fi­nan­cial mar­kets in a health­ier place to­day than a year ago, a shift to more of an ex­plicit over­shoot seems less likely.” Bloomberg

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