Fed's tightening cycle scenario involves risky bet on inflation

Fri Aug 21, 2015 1:12am EDT
 
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By Howard Schneider

WASHINGTON (Reuters) - Federal Reserve officials planning to lift interest rates as soon as September have been encouraged by solid U.S. jobs growth, but inflation holds the key to how far the Fed can go in moving rates away from zero.

Fed officials have said that they do not need to see prices accelerate to start raising rates after six years near zero, and "lift-off" appears nearly ordained by a 5.3 percent unemployment rate, the lowest since April of 2008.

But it would be a leap of faith to move any further without proof that prices are on the rise, say current and former officials familiar with the central bank's debate and the current state of inflation research.

If prices remain stalled as the Fed tightens, inflation-adjusted "real" rates would rise faster than the Fed wants, and threaten the recovery. Given the uncertainty among economists about how inflation works in the post-crisis world, it may be risky to assume higher prices will necessarily follow a tightening job market. (Graphic: here)

"There is a big component of inflation that is just going to be idiosyncratic and unexplained," leaving policymakers to take their best guess about it, said former Fed research director David Stockton.

He said that after an initial rate increase, Fed Chair Janet Yellen would lead her colleagues on a "cold, dispassionate examination" of what the inflation data are actually showing.

"If inflation is not moving back to target ... then she can argue for a go-slow approach."

  Continued...

 
A detail from the front of the United States Federal Reserve Board building is shown in Washington October 28, 2014. REUTERS/Gary Cameron