By Howard Schneider
WASHINGTON (Reuters) – The Fed needs to mount a clear defense of its 2 percent inflation target and stop raising rates until the pace of price increases strengthens, St. Louis Fed President James Bullard said on Thursday.
The central bank risks losing credibility, and perhaps triggering a recession, if it continues to insist on “normalization” and higher interest rates without better evidence that prices are firming, he said in an interview with Reuters.
“If you are going to have an inflation target you should defend it. If you say you are going to hit the inflation target then you should try to hit it and maintain credibility,” Bullard said.
Persistent weakness this year in the Fed’s preferred measure of inflation means “we more or less lost all the progress that we made the last two years” toward the 2 percent goal, Bullard said. Continuing to raise interest rates in that environment “can send a signal to markets that the inflation target is not that important.”
The Fed’s preferred measure of inflation slipped from 1.7 percent in April to 1.4 percent in June, July and August.
Bullard, a non-voter on policy until 2019, said colleagues who blame the decline on large, one-off price moves for some goods and services were too “finely chopping” their analysis, and overlooking the fact technology or some other force is restraining prices. The argument that recent weak inflation is driven by temporary factors is perhaps the dominant view at the Fed, with culprits including major changes in cell phone pricing and the impact of slower-rising Medicaid costs.
“This idea of throwing out the unpleasant number and finely chopping the price index, you get down to a set of prices that barely can be considered representative and I think that is inappropriate,” Bullard said. “Maybe this is temporary, maybe this will bounce back. What I say to that is you want to see evidence…This is going in the wrong direction. And it is not consistent with the stories that the committee has been telling,” of inflation reaching the Fed’s target in the “medium term.”
“If the committee continues to raise rates that could turn into a policy mistake…I think inflation could drift lower instead of higher. I think a misperception about where rates need to be in this environment could possibly trigger recession if it was carried to an extreme.”
INFLATION DEBATE INTENSIFIES
Bullard’s comments are a pointed intervention in a debate that is preoccupying policymakers worldwide, and forcing research into and a possible rethink of the way prices are set in the post-crisis world. Bullard himself completely reversed his assessment of inflation more than a year ago, flipping from among the committee’s hawks to now its most dovish.
The discussion has been joined at a time when the Trump administration is considering whether to reappoint or replace Fed chair Janet Yellen, whose term expires in early February. The short list has included three non-economists — current Fed Governor Jerome Powell, former governor Kevin Warsh, and National Economic Council chair Gary Cohn — whose professional background have centered around law and investment banking.
Bullard said the flux over how central banks think about inflation means “whoever comes into this job is going to face this smack the first day. This is where the debate is and it is no small matter as to how we should proceed.
“You are going to need pretty strong intellectual leadership on core issues in monetary policy to have a stable system moving forward…If it is not going to be an economist it is going to be incumbent on the economists on the (Federal Open Market Committee) and on the staff to carry that debate forward.”
Minutes of the Fed’s September meeting and officials’ recent public comments show them involved in a broad debate, arrayed on a scale from those worried inflation is permanently stuck, to those who feel it does not matter and that interest rates should be higher in a healthy economy.
It has led Chair Janet Yellen to publicly acknowledge the Fed may have misjudged key elements of what is happening in the job market, and prompted Gov. Lael Brainard on Thursday to say a new approach to inflation might help in a future downturn but at the risk of greater market volatility.
LOOSE FINANCIAL CONDITIONS ARE NO SIGNAL
The core of the committee has staked out a middle ground that another rate increase this year is warranted, with some arguing that ongoing loose financial conditions means the Fed can nudge short term interest rates higher without risk of slowing the economy. That, in turn, would guard against any likelihood that inflation is about to take off.
Bullard said he thought some of his colleagues have “hedged” recently. Minutes of the last meeting indicated a “few” Fed officials were ready to rule out another rate hike until inflation increases, while “several” have conditioned their view on stronger incoming data.
He pushed back specifically on the argument that loose financial conditions – characterized by high stock prices, muted market volatility and narrow credit spreads – are a reason to raise rates.
The indexes that measure those conditions are important as a sign of trouble when they show conditions tightening and volatility rising, he said. But when they indicate calm financial markets and looser conditions, they offer less meaningful information about what lies ahead.