A difference of opinion

There appears to be a difference of opinion at the US central bank. Federal Reserve Chair Jerome Powell’s top deputies are edging toward a clash that could shape the pace of interest-rate hikes in the coming months, as well as how the Fed should prepare for and combat the next economic downturn.

The fault lines are technical as well as philosophical and include a debate over whether the economy has shifted into a higher gear, giving the Fed room for more interest-rate hikes and perhaps reducing the need for controversial tools like bond-buying to fight future recessions.

They come as tax cuts and government spending boost growth and inflation, giving policymakers the breathing room to debate whether to retool the Fed’s basic policy approach to give themselves more firepower even if slower future economic growth is unavoidable.

San Francisco Fed President John Williams launched a critical salvo in the debate on Tuesday with a speech underscoring his view that the US central bank has only a few more rate-hikes ahead of it before rates reach a level of borrowing costs that allows the economy to coast along, without stimulating or slowing its progress. This “neutral” rate, which can only be estimated and not observed, serves as a sort of speed limit on rate-hikes and is at the heart of the current policy debate.

Williams, whose research has helped convince most of his colleagues that the “neutral” rate of interest is much lower than in the past, stands to become even more influential when he takes over as chief of the New York Fed next month, a position that will make him a permanent voter on the Fed’s policy-setting committee.

His view contrasts with recent optimism from some economists and central bankers. Among them is the Fed vice chair for financial supervision, Randal Quarles, a Trump administration appointee who in February said he believed there is a “real possibility” that the economy could shift to a higher growth trajectory.

Quarles’ view suggests that the Fed has a bit more room to raise rates without braking the economy, which would in turn give it the flexibility to cut rates more deeply in the next downturn, and perhaps avoiding the need for unconventional measures like bond purchases.

Fed Board nominee Richard Clarida, at his Senate confirmation hearing yesterday, flagged some discomfort with such measures, which began in the depths of the financial crisis to stabilise banks and were later expanded to help bring down high unemployment and lift excessively low inflation.

Although the Fed’s initial programme of so-called quantitative easing “made sense,” Clarida said he was not sure how he would have voted on subsequent rounds, and said in response to a question from Republican Senator Pat Toomey that he was “very sympathetic to your view that any discussion and thinking about QE would have to take a serious look at costs as well as benefits.”

Williams for his part on Tuesday called bond-buying an important part of the policy-easing tools that the Fed “is going to have to turn to” to fight future downturns. Rate-cuts alone, from what will be a relatively low starting point and only able to fall as far as zero, would not provide enough firepower to stimulate the economy, he has said in the past.

Williams has also said that “time is pressing” for a rethink of the Fed’s 2% inflation target. A new policy framework, he has said, conceivably could give the central bank more room for manoeuvre even with a low “neutral” rate by allowing it to defer rate-hikes after a recession even if inflation pushes up to, or even past, its long-run target.

Several other Fed policymakers, including Fed Governor Lael Brainard and Chicago Fed President Charles Evans, have lent support to a debate on the framework. Quarles by contrast has suggested that there is little need to rethink the framework if inflation rises back to the Fed’s 2% target, as it has lately done.

Clarida did not weigh in on that debate on Tuesday, or on his view of the “neutral” rate. But if he and fellow nominee Michelle Bowman are confirmed, it is a topic that will heat up in the coming months.

Alan McQuaid (16/5/18)
Economist