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Fed staff research anchors subtle shift that could lead rates higher

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By Reuters
Fed staff research anchors subtle shift that could lead rates higher
FILE PHOTO: A cyclist passes the Federal Reserve building in Washington, DC, U.S., August 22, 2018. REUTERS/Chris Wattie   -   Copyright  Chris Wattie(Reuters)

By Howard Schneider

WASHINGTON (Reuters) – The U.S. Federal Reserve should be ready to lift interest rates for a longer period or even more quickly than currently expected to insure against a jump in inflation in a U.S. economy operating in the vicinity of full employment.

That is the message that has been percolating up from senior central bank staff economists to policymakers including Fed Chair Jerome Powell in research that has helped inform a subtle shift in how Powell plans to steer policy amid growing uncertainty about concepts such as full employment and the neutral level of interest rates.

The latest example emerged this week from staff economist Robert Tetlow, who argued that uncertainty about the stability of inflation expectations should be met with a strong response to ensure that one round of price increases does not touch off further rounds as inflationary psychology takes hold.

Tetlow’s paper, released on Tuesday, follows Powell’s own remarks on Friday morning in which he explicitly cited the risk of unanchored inflation expectations as one of the cases “in which doing too little comes with higher costs than doing too much.”

Referring to a general rule of thumb among central bankers – that smaller, more cautious policy responses are appropriate in the face of uncertainty about key economic parameters – Tetlow said the central bank should not be shy if policymakers are unsure about inflation’s “persistence.”

“The proper response to uncertainty concerning inflation persistence is not the customary policy attenuation…but rather anti-attenuation, meaning a more aggressive response,” wrote Tetlow, a senior adviser in the Fed’s Monetary Affairs division.

Powell on Friday signalled he was wary of how accurately the Fed can estimate some of the variables that are important to the U.S. central bank’s models of the economy, including the level of full employment and the “neutral” rate of interest, and was thus hesitant to be guided strictly by how they interact.

“A skeptic would say that the models aren’t working – and this is what Powell is indirectly saying,” Robert Eisenbeis, chief monetary economist with Cumberland Advisors, wrote this week. “His answer is to fall back on risk management,” or weighing the cost of a mistake in either direction and choosing the less costly option.

In the current situation, that would mean continued and perhaps even faster rate hikes to guard against inflation, rather than holding rates lower to see if unemployment can drop further without accelerating the pace of price increases. Some regional Fed officials have made just that case, arguing there is no reason to raise rates until inflation takes off.

But “the starting point for the economy…raises the costs of underestimating” full employment, as happened in the 1960s when efforts to drive down the unemployment rate touched off high inflation, Goldman Sachs analyst Daan Struyven wrote in an analysis of Powell’s remarks and the new staff research.

Though prices today are better anchored than in the 1970s, “the concern about labour market overshooting is likely to drive steady tightening until payroll growth slows,” Struyven wrote, reiterating Goldman’s view that the Fed will raise rates four times next year and two more times this year.

That is slightly faster than the Fed itself anticipates.

(Reporting by Howard Schneider; Editing by Dan Burns and Leslie Adler)