Gavyn Davies
This week has seen speculation about a mutiny from two members of the Federal Reserve’s Board of Governors against the leadership of Janet Yellen and Stanley Fischer, both of whom continue to say that they “expect” US rates to rise before the end of the year. Although “mutiny” is a strong term to describe differences of opinion in the contemplative corridors of the Federal Reserve, there is little doubt that the institution is now seriously split on the direction of monetary policy.
Furthermore, these splits could extend well beyond the date of the first rate hike to the entire path for rates in the next few years. Janet Yellen faces an unenviable task in finding a compromise path that both sides of the FOMC can support.
This week’s “rebellion” within the Board was led by Lael Brainard, a rookie Governor who was previously an Undersecretary at the US Treasury, working on international economics.
During the euro crisis, her frequent trips across the Atlantic won her respect, and marked her out as a clear thinking Keynesian who wanted emergency action from the ECB long before Mario Draghi came to that view.
It is therefore no surprise to see her emerging as the “uber dove” on the Board of Governors. In a speech notable for its clarity, she directly opposed several of the main planks in the Yellen/Fischer orthodoxy (see Tim Duy and Paul Krugman.) For example, she said that the Phillips Curve is an unreliable guide to future inflation rates; that the predicted rise in the equilibrium real interest rate might never happen; and that the appropriate management of inflation and recession risks clearly pointed towards long term dovishness.
Ben Bernanke’s recent memoirs commented that divisions among the Board of Governors in Washington are more significant than divisions on the much larger and less disciplined body that sets monetary policy, the Federal Open Market Committee.
In 2013, Ben Bernanke faced a rebellion from three of his Board members, who wanted to taper the Fed’s asset purchases earlier than he did. His memoirs state that a rebellion from 3 of the 7 Board members would have made his position as Chair “untenable”, so he had to address this risk by accepting earlier tapering. The fact that he then became the spokesman for a messy compromise probably contributed to the miscommunications about the Fed’s intentions that were such a problem during the “taper tantrum” that summer.
It is possible that Ms Yellen is facing a similar problem today, though this time her opposition on the Board is coming from a dovish, not hawkish, direction. There are now only 5 seats on the Board actually filled, and two members (Brainard and Daniel Tarullo) indicated last week that they are opposed to a rate rise this year.
That is a tough obstacle, especially since the Brainard arguments about the downside risks to the US economy, and the tightening in monetary conditions that has already happened, are clearly also shared by Bill Dudley. Although Mr Dudley is not a Board member, he has a special position as Deputy Chairman of the FOMC and a permanent voter.
On the other side of the debate, however, the Vice-chair of the Board of Governors, Stanley Fischer, has consistently staked out a position in favour of early “normalisation” of interest rates, now that the labour market seems to have returned almost to normal. This view is supported by James Bullard and some other regional Presidents, probably including John Williams who replaced Ms Yellen at the San Francisco Fed. Up to now, it was thought that Ms Yellen herself might be leaning towards a rate rise in order to avoid dissents from this group of hawks, but now she faces the risk of dissents from either end of the spectrum.
One theory is that Ms Yellen is, in reality, a closet dove who has been irritated by the more hawkish public statements of her Vice-chair Mr Fischer. But, if so, why did she go so far out of her way to identify herself as one of the members of the FOMC expecting a rate rise this year in her recent comprehensive speech about inflation? That speech, delivered only three weeks ago, was intended to lay out the case for a pre-emptive rate rise, ahead of any concrete sign of rising inflation.
Another theory is that Ms Yellen has some predisposition towards “normalisation”, but is very influenced on the timing of the first hike by the flow of data. On this view, she keeps saying that policy is “data determined” because that is precisely the case. It would therefore be no big deal if she decided that the recent softness in US activity was a sufficient reason to delay the first rate rise by a month or two.
Again, Mr Benanke’s memoirs are relevant here. Going into the September 2013 meeting that unexpectedly decided against tapering, he was apparently much less certain about the appropriate policy than the market’s assumed him to be, entering the meeting. He wanted to do “the right thing”, rather than worrying too much about surprising the markets on the day.
Ms Yellen has always included so many caveats about her “expectation, not commitment” on raising rates that she will have a ready made alibi if she now changes her mind. Nevertheless, she will lose some credibility, and markets will pay less attention to her “expectations” from now on.
Perhaps more important, the Brainard speech will encourage people to believe that her fundamental objections to tighter policy are gaining ground at the FOMC, in which case the markets may conclude that there is little chance of a rate rise anytime in 2016. Ms Yellen will certainly not want that to happen.
So what will happen in December? The outcome looks increasingly uncertain. Ms Yellen herself still seems to believe that a rate rise is her central case but, this time, the ultimate decision really will be “data determined”. The growth rate in US economic activity has now dropped to only about 1-1.5 per cent. That means that the onus of proof has now completely changed: there needs to be an improvement in the data to keep a rate rise on the table.
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