WASHINGTON (Reuters) - An improving U.S. economy has exposed a widening rift at the Federal Reserve over how quickly to scale back the central bank’s aid measures, a debate that will be front and center when policy-makers meet next week.
A steady drumbeat of surprisingly positive economic data and a rise in investor appetite for risk, which have pushed the Dow Jones industrial average to 11-month highs, puts a robust economic recovery on the table as a possibility.
Heightened prospects for a strong resurgence — rather than the sluggish rebound many still envision — have led some officials to worry an inordinate delay in scaling back the enormous support the Fed has given the economy could squander its inflation-fighting credibility.
Others, however, continue to focus on high unemployment and the slow downward drift in measures of U.S. core inflation, a camp that is likely to hold sway when the policy-setting Federal Open Market Committee (FOMC) meets on Tuesday and Wednesday.
“In my career, I have never witnessed a situation like the one that exists now, when views about inflation risks have coalesced into two diametrically opposed camps,” San Francisco Federal Reserve Bank President Janet Yellen said on Monday.
The course of the debate will drive the Fed’s decision on how quickly and aggressively to remove its extraordinary programs aimed at reviving lending and hiring.
“Tensions on the FOMC will increase with the improving economy,” said Mark Zandi, chief economist for Moody’s Economy.com. “The debate is going to intensify.”
At issue is how the Fed unwinds the unprecedented support it has provided the economy by cutting benchmark interbank lending rates to near zero percent, lending hundreds of billions of dollars, and buying up government and mortgage-related debt in order to keep interest rates low.
Many of the lending programs have begun to shrink as markets stabilize, and the Fed has already announced the end of the longer-term Treasury buying program. As the economy recovers, however, the Fed will have to carefully time and calibrate an exit strategy of ending its buying and lending programs and eventually raising interest rates.
Some policymakers worry that undue angst over whether the Fed’s bloated balanced sheet may spark inflation could lead the central bank into tightening policy before a self-sustaining recovery is solidly off the ground.
The possibility of a hurried exit haunts these officials, who are mindful that central banks killed recoveries with premature rate hikes in the United States in the 1930s and in Japan in the 1990s.
Fed officials have staked out turf on both sides of the argument.
Richmond Federal Reserve Bank President Jeffrey Lacker, a noted policy hawk, has said the central bank should consider curtailing a program to buy up to $1.45 trillion in mortgage-related debt that has successfully lowered U.S. mortgage rates.
“We may need to consider whether to continue adding more stimulus,” Lacker said on Monday.
At the other extreme, Yellen said on Monday that the recovery is likely to be tepid and that even one quarter of strong growth would do little to dent an unemployment rate that hit a 26-year high of 9.7 percent last month.
She said the greatest economic threat is not inflation but disinflation — a slowing inflation rate that opens up the prospect of deflation, a broad drop in prices that could trap the economy in a dangerous downward spiral.
Comments on Tuesday from Fed Chairman Ben Bernanke suggested the consensus lies closer to Yellen than it does to Lacker.
While Bernanke said for the first time that the U.S. recession is probably over, he stressed that a dismal job market will likely cause discomfort well into next year.
Many analysts believe worries about unemployment will carry the day.
“The key to Fed policy decisions is what happens in U.S. labor markets,” said Michelle Meyer, an economist with Barclays Capital in New York. “They need to see the unemployment rate peak and actually fall a considerable amount before the Fed is comfortable with raising rates.”
A Reuters poll released on Wednesday showed economists expect the Fed to hold rates steady until the third quarter of next year.
While policy-makers will likely debate the course of the mortgage support program, which is slated to terminate at year’s end, a decision may not come next week.
“One would expect some withdrawal of support from the mortgage market as mortgage conditions get better but that’s also a question of when, not whether,” said Allen Sinai, chief global economist at Decision Economics in New York.
“At this meeting, in the majority view of those most in control, it’s premature,” he said.
Some Fed officials believe the bar should be set high before the central bank pulls back on announced asset purchases that financial markets now expect, a point of view that seems likely to prevail.
Indeed, Fed officials are considering stretching out their mortgage-debt purchases into next year to avoid disrupting markets.