The Financial Times

June 17 2008

Federal Reserve officials and financial market investors agree on one thing: that the US central bank will probably have to start raising interest rates again in the not too distant future. Where they disagree, however, is how soon? And how fast?

In recent days the market has gone from pricing in one rate increase by the end of the year to pricing in at least three and possibly four. This does not appear to match the balance of views within the US central bank.

There are two schools of thought inside the Fed. The first holds that the Fed cut rates to extremely low levels – particularly in real (inflation-adjusted) terms – to deal with the “tail risk”. That is an outcome that is not likely to materialise but would be very costly if it did – in this case that there would be a very severe recession.

In doing so the US central bank went further than would have been justified based only on policymakers’ base case forecasts for weak growth.

As chairman Ben Bernanke said in a speech last week, the tail risk to growth has now receded significantly. While bank shares have weakened again in the past month, markets overall have made visible progress since March and consumer spending has held up well.

If a large part of the rate cuts were to deal with the tail risks, the hawks argue, these cuts should be taken back as the tail risks decline, even if the base case outlook has not improved much.

Jeffrey Lacker, president of the Richmond Fed, said on Monday “just as easing policy aggressively in response to emerging downside risks made sense, withdrawing some of that stimulus as those risks diminish makes eminent sense as well”.

Some Fed officials argue that there is now a heightened tail risk on the inflation side. They urge rapid rate normalisation – at least part of the way – to pre-empt any further increase in inflation expectations.

But a second school of thought inside the Fed which does not share this conclusion. This more dovish group argues that even though the Fed set out to combat tail risks by cutting rates aggressively, in practice a large part of the rate cuts simply offset the tightening in financial conditions that would otherwise have been caused by the credit crisis. Overall financial conditions are easier now than they were in August 2007, but not very much easier.

Yet the economy is much weaker today than it was in August 2007. Growth remains weak and unemployment is rising, even setting aside the remaining downside risk from housing and the financial sector.

Therefore, the Fed doves argue, the current level of interest rates may not be wildly inappropriate even relative to the base case for growth.

These officials are less concerned about the tail risk to inflation, given the offset to higher oil prices from rising unemployment. They would back aggressive action if inflation expectations broke higher, but are not minded to move to lock down expectations.

These officials still envisage raising rates as market strains ease, the growth outlook improves, and to offset any rise in expected inflation, leaving real rates unchanged. But the pace of rate increases they anticipate is considerably slower than the first group.

Mr Bernanke has not yet shown his hand. He may stand somewhere between these two schools of thought. But he is likely to share at least a good part of the Fed doves’ thinking.

The market, meanwhile, appears to be taking its cue from the first group. Since the second group is influential, this could turn out to be a mistake.