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Fed’s debate shifts from lift-off to long march to normal

WASHINGTON (Reuters) – For the Federal Reserve, deciding when to raise rates for the first time in nearly a decade has become the easy part.

The harder call, and one increasingly preoccupying U.S. central bankers, is how fast to move after that, navigating stuttering global growth and nervous markets on the Fed’s long journey back to pre-crisis policies.

Betting on the “lift-off” of rates from near-zero has become less of a gamble, particularly after an exceptionally strong jobs report last Friday. After months of wavering as the global economy appeared to weaken, investors have pegged that first rate rise to the middle of next year, and seem to have accepted that the U.S. economy can go its own way.

Recent conversations with Fed policymakers, staff and economists point to an internal debate shifting from the first rate move to the pace of increases thereafter. Stagnant inflation has become less of a concern in light of continued improvement in labor markets. Barring a serious shock, policymakers have indicated they will press ahead with liftoff in coming months, then move cautiously to ensure they do not stifle the recovery by acting too fast.

“Getting started is probably helpful… Otherwise you keep deferring and keep deferring and then the market just keeps pushing this further out… You want to break the glass,” said one former Fed official familiar with the debate. From that point on “if inflation stays low you can be in a little bit less of a rush… You don’t have to go every meeting.”

That sentiment is taking root at the Fed and narrowing the differences among the 7 governors and 12 regional bank presidents, who only a few months ago appeared broadly split over issues such as the amount of slack in the labor market. Fed officials will update their forecasts after meetings that conclude on Dec. 17, possibly marking a further convergence of their views.

Naturally, some disagreement remains. Inflation hawks feel the Fed should be acting sooner to prevent crisis-era stimulus feeding into asset price bubbles and excessive price increases. Others, most notably Minnesota Fed chief Narayana Kocherlakota, worry the central bank is too complacent about a risk of inflation fading. A financial crash in China or some other shock could also turn the Fed’s timetable on its head.

But with an economy less dependent on trade and with strengthened banks, the United States looks more robust than recession-prone Japan and Europe. More jobs, rising wages and stock prices and other positive domestic news, meanwhile, may set the stage for households to play a larger role in the recovery.

“Everything is coming together for pretty solid consumer spending growth,” said Mark Zandi, chief economist at Moody’s Analytics.

Even the Fed’s more cautious members are eager to deliver a modest rise in the benchmark rate, according to interviews with officials, staff and analysts. A zero interest rate leaves policymakers no simple way to react if conditions weaken; it is also increasingly out of step with data that has boosted the Fed’s confidence about the economy’s momentum.

In fact, central bankers have become so confident that even a clear acceleration in prices is no longer seen as a precondition to liftoff, Fed policymakers and staff have indicated in interviews and public statements.

There is wide recognition that cheaper oil and the strength of the dollar, for example, mean the Fed’s preferred inflation measure may remain stuck at around 1.5 percent in coming months. That is considered far below the central bank’s 2 percent target given the glacial pace at which U.S. prices and wages are now thought to move.

BEYOND OIL

In a recent series of interviews with Reuters and in public statements, policymakers have said they are trying to look beyond oil’s direct impact on inflation to other factors that will ultimately drive prices and wages higher. Cheaper oil is likely to dampen energy sector investment and hiring in the short-run, for example, but over time will boost overall demand, perhaps boost profits and hiring among other firms, and ultimately produce stronger growth. Fed officials are also looking for confirmation of longer term price and wage trends in factors such as capacity utilization, job turnover, the time it takes to fill jobs, and a range of surveys and measures of inflation expectations.

“We may have to disentangle short term influences of energy prices from the underlying trend… But I really do believe we will see the underlying core pace of inflation accelerate,” Atlanta Fed President Dennis Lockhart told reporters last week. Lockhart, a centrist member who will have a vote next year on the Fed’s policy committee, said that while a mid-2015 lift-off was not “carved in stone,” he saw the data increasingly backing that scenario.

Now the question is where rates will be at the end of 2016 or even farther into the future. The initial hike, probably a small, quarter point move, may have little effect on what companies or consumers pay for credit, the patterns of lending among banks, or cross-border capital flows. But the quicker the Fed moves from there, the faster will be the adjustments and the greater the potential for dislocation.

Indeed if Fed policymakers and the markets are coalescing around liftoff, they remain far apart about what happens next. The most recent projections by Fed officials, provided in September, anticipate a median federal funds rate of 3.75 percent by the end of 2017. However, some futures contracts show investors do not expect the benchmark rate to reach such levels until well into the 2020s.

As Fed chief Janet Yellen and other Fed officials have noted, that gap could reflect a number of things – from divergence in economic forecasts to differing views about how the Fed may respond to economic data. Some analysts have noted, for example, that Fed economic projections have tended to be optimistic; others speculate that Yellen’s personal rate projection is probably on the lower end, and weight their predictions to account for her more influential voice.

(Additional reporting by Michael Flaherty and Jonathan Spicer; Editing by Tomasz Janowski)