Fed Adviser Adds to Argument That May Back Higher Interest Rates

(Bloomberg) -- Low inflation has long confounded the Federal Reserve’s models, leading central bankers to keep interest rates lower than they otherwise would. Now, with a key measure of inflation at their 2 percent target, some of the Fed’s top economists are urging policy makers to put more focus on the risk that it could accelerate.

The price index for personal consumption expenditures excluding food and energy -- a gauge Fed officials watch closely to get a sense of underlying price pressures -- rose 2 percent in July from a year earlier, according to Commerce Department figures published Thursday. Until earlier this year it had fallen short of that level for almost six years.

And if Fed Chairman Jerome Powell is inclined to take his staff’s advice, underlying inflation back at 2 percent may prove to be a timely marker for a policy shift in which officials begin to err more on the side of doing too much with interest-rate hikes than not doing enough.

That’s the takeaway from a note published Wednesday on the Fed’s website. The author, Robert Tetlow, is a senior adviser in the monetary affairs division, which informs Powell and the other Fed governors in Washington about how to make policy based on what’s happening in the economy.

Tetlow’s memo built on ground covered in Powell’s Aug. 24 speech in Jackson Hole, Wyoming. In the speech, Powell discussed how uncertainty about changes in the economy over time inform the Fed’s interest-rate policy deliberations.

The Fed chief cited a famous 1967 paper by Yale University economist William Brainard, which many central bankers since have interpreted as counseling less-aggressive policy responses to changes in economic data when there is uncertainty about whether the underlying structure of the economy has changed.

Powell said there were two major exceptions. The first is when the Fed is near the zero bound on interest rates, like it was during the financial crisis and in the years that followed. The second is when inflation expectations appear to be drifting higher.

“If expectations were to begin to drift, the reality or expectation of a weak initial response could exacerbate the problem,” Powell said.

‘More Aggressive’

The Tetlow note published Wednesday is all about that scenario. For staff economists at the Fed, that’s the more relevant risk at the moment, given how low the U.S. unemployment rate has fallen in recent months.

“The proper response to uncertainty concerning inflation persistence is not the customary policy attenuation, in the sense of Brainard (1967), but rather anti-attenuation, meaning a more aggressive response to inflation than is the case when the inflation persistence parameter is known,” Tetlow wrote.

The paper follows another Tetlow co-authored, along with other top Fed economists, that was published a day before Powell’s speech. The researchers cited the 1970s experience, in which high inflation combined with a weak interest-rate response from the Fed triggered a persistent increase in inflation expectations, which took more than a decade to correct.

The takeaway from that paper was that Fed officials shouldn’t ignore low unemployment simply because inflation hasn’t taken off yet, even if they’re not exactly sure what level of unemployment would trigger higher inflation.

The idea is that, with inflation back where the Fed wants it, it’s best to return to setting interest rates based not just on price gains but also on the gap between unemployment and their estimate of the sustainable jobless rate. According to projections in June, Fed officials believed that sustainable rate was around 4.5 percent. The jobless rate was 3.9 percent in July.

If Powell takes the staff’s advice, interest rates could rise next year above what investors have priced into futures markets. Right now, futures indicate Fed officials will probably keep hiking for the next 12 months, and then stop. That would be more or less in keeping with their strategy to date, because the bond market also sees little risk of further increases in the inflation rate from here.

But if Fed officials begin to heed unemployment more as an input to policy making, investors may have to rethink what the Fed is likely to do going forward.

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