Fra Commerzbank:
Power struggle within the Fed
There is a major conflict within the Fed over the course of monetary policy. Two members of the Federal Reserve Board have staked out their position against Fed Chair Yellen, who only recently flagged a first rate hike before year-end. The exit from the zero interest rate policy thus appears to be turning into a power struggle although in our view, Yellen will push through a rate increase in December. For the period thereafter, however, the market is not pricing in enough rate hikes. Board members shift to the side of the doves …
The decision as to whether interest rates should be hiked for the first time since 2006 will not be an easy task for the Fed, as data are not painting a clear picture: On the one hand, the headwinds from emerging markets are increasing, the dollar has appreciated markedly and the inflation rate is well below target. On the other hand, the domestic economy is robust and full employment has all but been achieved. Hence, it does not really come as surprise that there are conflicting opinions among the leading policymakers.
Normally, such differences are largely waged in public only by the twelve regional Fed presidents. But this time, the inner leadership circle comprised of the Federal Reserve Board, seems also to be deeply divided, as suggested by a truly sensational speech by Lael Brainard, who joined the Federal Reserve Board in 20141 . According to Brainard, the risks for the US economy are currently tilted to the downside, largely driven by “progressively gloomier projections of global demand”. She argued that this is already weighing on financial markets, stating that the effect of a sharp increase in the dollar has been equivalent to a couple of rate hikes.
Moreover, she raised serious doubts whether the improvement in the labour market is sufficient for the desired increase in inflation. Against this backdrop, she advised the Fed not to raise rates in 2015. Daniel Tarullo, another member of the Board, took the same view.2 What makes these statements extraordinary is that both Chair of the Board Yellen and Vice Chair Fischer held speeches in recent weeks that placed them in the camp of officials who favour raising rates in 2015. Normally, the members of the central board (which by statute consists of seven of the twelve voting members on the Federal Open Market Committee3 ) take a unanimous position which is determined by the Chair of the Federal Reserve Board.
If the majority within the FOMC decided to hike rates at one of the two forthcoming meetings, two of the Board members might vote against Yellen, which would be extremely unusual. … but the hawks are still relying on the Phillips curve One reason why the doves are going on the offensive seems to be that support for the hawks has been growing. Thus, the minutes of the Board’s last meeting show that eight of twelve regional Federal Reserve Banks in September argued in favour of hiking the discount rate.
Apart from Yellen and Fischer, the President of the New York Fed, Dudley, also signalled that he stands ready to raise rates by year-end 2015. Last but not least, the open conflict within the Fed is a struggle of economic ideologies, which essentially revolves around the Phillips curve, or the question as to whether there is a reasonably stable relation between capacity utilisation (as reflected by the unemployment rate, or more particularly the gap between the unemployment rate and the “natural” level of unemployment) and inflation. Hence, solid growth and the resultant increase in labour demand, whilst unemployment is declining, should sooner or later lead to higher wage increases and higher inflation rates. The majority in the FOMC believes this to be true, whereas the doves are calling it into question.
From the economic issue to a matter of power For Janet Yellen, the struggle goes beyond an intellectual debate over the validity of the Phillips curve. In fact, Brainard and Tarullo have publicly called into question the validity of Yellen’s views who only recently argued in a key speech that the Phillips curve is a reasonable instrument on which to base monetary policy, and which would signal a first rate hike in 2015.4 If Yellen were to give in to the doves, she would seriously weaken the traditionally strong role of the Board Chair. The decision on the first rate increase has thus turned from an economic debate into a power issue. In our view, the balance of probabilities suggests that Yellen will go ahead with a first rate hike in December, in order to resolve the power issue.
She and Vice Chair Fischer will likely try hard to reduce the number of three dissenting votes (besides Brainard and Tarullo, Evans from the Chicago Fed might dissent). However, it would not be the first time that an important and controversial decision is pushed through in the face of opposition. This should be a price Yellen is willing to pay. Moreover, remaining on hold in December would provoke opposition from the hawks. Time for Yellen to put an end to communication chaos The public display of discord is not only undermines Yellen’s position but also the Fed’s communications. Clear communication is after all an essential element of effective monetary policy. Public differences of opinion among leading Fed members – particularly if they reveal major divergence on the Board – only serve to obscure the Fed’s course of action. It is increasingly less apparent to observers just how the Fed responds to data.
So the Fed chairman will have to take control of the reins very soon. The markets need a clear signal, and the Fed will have to decide between two options: • Either Yellen abandons her own position and backs the views of Brainard and Tarullo. It would then be clear that a rate hike is not imminent. It would also be clear that the Fed is taking more notice than previously of global economic influences. And finally, the financial markets would feel justified in their sceptical assessment of the scope available to the Fed in raising interest rates. The power struggle mentioned above makes this option unlikely. • Alternatively, Yellen will have to make it clear very soon that she wants to push through a rate hike before the end of the year.
And she must do so unequivocally before the FOMC meeting in mid-December, since this is when a rate hike would most probably be approved. Otherwise, the shock of a rate hike would be too great, as market expectations increasingly believe that nothing will happen. In our view, this second scenario of lift-off in December is the more likely option. Once the power issue is resolved, attention can turn again to data While the first move is likely to be prompted largely by power considerations, subsequent decisions should be based on economic data. It will then become clear whether the Phillips curve adherents are right. If so, we could see a steeper rise in interest rates than the market is currently assuming. Alternatively, the sceptics will be proved correct, and then the process of rate hikes would probably come to an early end. What do the data say? One of the doves’ arguments is that the unemployment rate paints too rosy a picture.
They claim that under-utilisation of labour market resources is greater than suggested by the unemployment rate, as many unemployed have given up looking for work owing to the limited prospects of finding a job. The evidence they put forward is the fall in the participation rate which dropped drastically during the 2008/9 crisis and has not since recovered. Despite a seemingly lower unemployment rate, the doves claim that this ‘reserve army’ is hindering more substantial pay rises and thus rising inflation. We do not believe that this argument holds water after five and a half years of steady job growth. Payroll growth has remained robust at around 2% p.a. and should long have tempted potential workers from the reserve pool back onto the labour market. This has not happened, though, and the participation rate has not recovered which is a strong indication that this ‘reserve army’ simply does not exist and the decline in participation is due mainly to demographic change in an aging society and longer-term changes in employment practices, i.e. it has little to do with the business cycle (see chart 1).
