The Federal Reserve meets this week amid an increasingly noisy debate – both inside and outside the central bank -- over the timing and pace of interest rate hikes.
Signs inflation is creeping higher as the rest of the economy slowly stabilizes have raised calls for the Fed to lift rates sooner than the central bank previously anticipated. Liftoff for rates is generally forecast for mid-2015.
The policy setting Federal Open Markets Committee meets Tuesday and Wednesday with a statement scheduled for release at 2 p.m. the last day of the meeting.
Rates have been held at near-zero since December 2008, when they were lowered to a range of 0%-0.25% at the height of the financial crisis in an effort to reduce borrowing costs and spur economic activity.
Now, more than five-and-half years later, the economy has recovered to a point where the Fed is poised to start hiking rates as part of a broader strategy of ‘normalization’ in which the unprecedented stimulus policies of the past few years are phased out.
When and how the Fed plans to wind down those policies has dominated these meetings for months.
The FOMC will almost certainly continue tapering its asset-purchase program known as quantitative easing, voting to slash another $10 billion in bond purchases each month and reducing QE to $25 billion per month from $35 billion.
The FOMC unanimously agreed to end QE in October if the economic data continues to show momentum.
The ongoing debate over raising interest rates is far more contentious, however.
The consensus among the most influential Fed policy makers – led by Fed Chair Janet Yellen and her band of inflation ‘doves’ – is the central bank should remain cautious and not raise rates too soon.
But a rapidly improving labor market and indications consumer prices are starting to move higher is putting pressure on Yellen and her faction to shift positions toward those of a vocal group of FOMC inflation hawks who believe rates should move higher sooner, possibly as early as the first quarter of 2015.
'Advancing the Day' of Rate Hikes
David Kelly, chief global strategist at JPMorgan Funds, acknowledged the shifting landscape in a note to clients: “A continuing tightening of the labor market is gradually advancing the day of the first increase in short-term interest rates, perhaps to the first quarter of next year, a reality that the bond market seems, so far, to be blithely ignoring,” he wrote.
The argument in favor moving rates higher sooner rather than later holds that an improving job market will push wages up and increase consumer spending, which will in turn push prices higher and lead to inflation.
FOMC inflation hawks are concerned rising consumer prices could swiftly morph into runaway inflation as the U.S. continues to absorb the trillions of dollars pumped into the U.S. economy via the Fed’s years of easy-money stimulus policies.
Inflation ran well below the Fed’s 2% target rate for months, but the rate has been creeping higher. The Fed’s preferred inflation measure, the personal consumption expenditure (PCE) price index, rose 1.8% in May from a year earlier. Its 12-month gain was as low as 0.8% in February.
Inflation doves are concerned if interest rates are raised too soon, the higher cost of borrowing could push inflation lower again and potentially serve as a catalyst for deflation, in which falling consumer prices lead to a vicious cycle of falling wages and reduced demand for consumer goods.
Also on the Fed’s plate this week is the method by which the central bank will raise interest rates and at the same time reduce its $4.1 trillion bond portfolio accumulated through QE.
The Fed currently reinvests proceeds of maturing bonds into new bonds, which keeps its bond portfolio at the current historically-high level. FOMC inflation hawks believe the Fed should start scaling back on the amount of assets it holds, and one way to do that is to stop reinvesting the proceeds from maturing bonds into new bonds. The question facing FOMC members this month is the timing for ending that reinvestment program: Should they end it before interest rates move higher or wait until rate liftoff?
Dallas Fed Chair Richard Fisher, a vocal hawk, wrote in the Wall Street Journal Monday the economy appears ready for the Fed to begin hastening its ‘normalization’ policies. Waiting too long could pose a risk to the economy, he noted.
The Fed said rates won’t move higher until the central bank achieves its dual mandate of full employment and price stability, defined as unemployment at a range of 5.2%-5.6% and inflation at a range of 1.7% to 2%.
Fisher notes the economy is approaching those thresholds faster than anticipated and the time for shifting monetary policy might also be coming faster than expected.