The US Federal Reserve – Birds of a Feather

Thinking Aloud

What do you get when you cross a hawk with a dove? A fair amount of confusion, if the US Federal Reserve (the Fed) is anything to go by.

At this year’s Jackson Hole gathering of the world’s central bankers, Fed Chair Janet Yellen declared that ‘the case for an increase in the federal funds rate has strengthened in recent months”. Markets reacted by marking up the chances of a rate rise this year to around 60%, from below 10% in the aftermath of the UK’s European Union referendum. But much of the recent debate inside the Fed has been about policy loosening, not tightening, and whether the central bank has the necessary tools to do that job in future years. So is the world economy being led by hawks or doves?

The answer is a bit of both. And that’s because the debate within the Fed encompasses not only a short-term horizon but also a longer-term one.

With policy interest rates having risen only once so far in an eight-year recovery, the case for a modest rate rise this year appears strong

On the former, the majority on the Fed’s decision-making committee appears to agree with Ms Yellen that the US economy is strengthening, led by a solid expansion in household spending. While the published pace of economic growth has been pretty anaemic so far this year, the labour market has remained healthy and job creation has averaged a respectable 190,000 in the past three months. Looking ahead, the Fed expects continued moderate growth, further strengthening of the labour market and – crucially – a pick-up in inflation in the next few years. Based on this economic outlook, and with policy interest rates having risen only once so far (December 2015) in an eight-year recovery, the case for a modest rate rise this year appears strong.

But this is where it gets more complicated. There are Fed members – including Esther George of the of the Kansas City Fed and Stanley Fischer, Ms Yellen’s influential deputy – who believe that rates should rise for what might be termed ‘hawkish’ reasons.

Their argument is threefold. First, they believe that, with core inflation (stripping out potentially volatile components such as food and fuel) in hailing distance of the Fed’s 2% target and impressive gains in employment, any further delay risks an overshoot. Second, they are concerned about the risks to financial stability of low interest rates, as investors take increasingly risky bets in search of decent returns. Finally, when scanning the horizon (in a suitably hawkish way), they don’t like what they see. Close to a decade on from the first signs of what ultimately became the global financial crisis, they are worried that we could soon be entering another downturn without sufficient room for policy manoeuvre. After all, the Fed has historically responded responded to recessions with rate cuts of around 5 ½ percentage points. It is very far from having that amount of ammunition today.

So unless rates rise substantially and soon, the argument goes, the Fed will be left powerless when it is needed most. Hawks in this camp may not feel comfortable, therefore, until US interest rates are quite some way above their current lows.

What about the rate doves? They fall into a couple of camps (or nests).

In one, there are those who would back a rate increase or two, given the progress made by the US economy in recent years. However, this group is less enthusiastic about the need for additional policy tightening beyond the very short term. In their view, the ‘neutral’ rate of interest – that which, by neither stimulating nor suppressing activity, helps maintain the economy on an even keel – has fallen in recent decades. The underlying reasons for this decline – ageing populations, slower productivity growth, emerging markets seeking large reserves of safe assets and a broader worldwide savings glut – will remain with us for the foreseeable future.

By implication, therefore, central banks will need to raise interest rates by less than in the past to bear down on inflationary tendencies: if the inflation-adjusted US neutral rate is close to zero, as many doves believe, the current fed funds rate of 0.5% may be far from creating the lurid inflationary risks that keep the hawks awake at night. And far from worrying that the Fed will be left without ammunition when the next downturn comes, they point to a range of options. Ms Yellen has highlighted recent Fed research suggesting that more asset purchases and ‘lower for longer’ forward guidance can bolster the effectiveness of modest rate cuts. More radically, John Williams of the San Francisco Fed has advocated a rise in the inflation target or abolishing it altogether, and focusing instead on the level of prices or the monetary value of economic activity (nominal GDP).

The second dovish ‘nest’ is more sceptical about the need for higher interest rates, even in the short term. Jerome Powell, Governor of the Chicago Fed, has spoken about the difficulty of raising US interest rates “in a world where everyone else is cutting and demand is weak around the world”, given the upward pressure on the dollar that this situation has created. For Mr Powell, and those of a similar mindset, the burden of proof for a rate rise is high – and includes an absence of “global risk events” as well as the presence of domestic strength. Circling around this nest are a number of vocal external commentators – former US Treasury Secretary Larry Summers being one – who would argue against the need for any rise in US interest rates at this stage. They are not convinced that the US economy is in robust health and that tightening is needed to stave off inflationary risks. Rather, they emphasise the country’s poor productivity record and the measures needed to tackle it. In their view, the prolonged period of relatively anaemic demand following the financial crisis may have damaged the economy’s ability to grow at a healthy pace in future, by undermining investment activity.

Their solution? If the private sector is reluctant to invest, bring in the government instead. This also doubles up as their answer to the hawks’ concern over a perceived lack of monetary policy tools: switch to fiscal stimulus if the central bank toolkit is looking a little well-worn.

And on that note we come to the one point on which pretty much everyone agrees: it is unrealistic, even irresponsible, to expect central banks to have all the solutions. Will we get a concerted fiscal response at the G20 summit in September? On past experience, it seems unlikely. In the meantime, US interest rates may well be raised modestly this year. But beneath that rather unexciting act, big issues are being debated in the Fed’s corridors. Watch out for flying feathers.


By Lucy O’Carroll, Chief Economist, Investment Solutions at Aberdeen Asset Managers Limited.  This article originally appeared on the Aberdeen Assest Management ‘Thinking Aloud’ blog on 1st September 2016