MNI INTERVIEW:NY Fed Adviser Fears Price Expectations To Spike

The Federal Reserve's promise to keep interest rates near zero until it has fully reached inflation and employment goals risks a delayed monetary tightening that will spark a dangerous unanchoring of inflation expectations, NY Fed Adviser John Cochrane told MNI.

In comments echoing growing concerns in central banking circles of a potentially serious policy mistake, Cochrane, a member of the New York Fed's Financial Advisory Roundtable, said the Fed "needs to think harder about what actually does anchor expectations."

"They seem to take it as granted that expectations won't budge, or that expectations can be managed with speeches and complex policy frameworks. Keeping expectations anchored needs careful tending," he said in an interview.

Cochrane is worried policymakers have not recalibrated the policy outlook to account for the rapid shift in fiscal policy toward a more proactive series of packages totaling some USD6 trillion.

"Fiscal policy is the big danger," said Cochrane, echoing the concerns of another regional Fed adviser who recently spoke to MNI. "Debt to GDP was 25% in the late 1970s, now it's 100% and climbing higher. This will make substantial rate hikes harder, as any rate hike raises interest costs on the debt."

The U.S. budget deficit surged to a record USD1.71 trillion in the first half of fiscal 2021, up from USD743 billion for the same period a year earlier.

"The larger issue is that there is no plan in sight for repaying debt or even just returning to zero primary surplus."

EVERYTHING IS TRANSITORY

Several current and former Fed staffers have voiced concerns about the central bank's ability to keep up with the recovery's surprising momentum, particularly in the wake of fiscal action on a scale not seen in the post-WWII era. But Fed Chair Jerome Powell pushed back against the notion in his most recent press conference, saying that it would take time for inflation expectations to rise.

A shift in its policy framework last year means the Fed now aims to overshoot its 2% inflation target modestly for some time in order to raise inflation expectations deemed to have been too low for too long. In addition, its definition of full employment was made more ambitious and inclusive.

Cochrane said these changes were well-founded in principal, if difficult to implement smoothly in practice.

"Promising to keep rates at zero no matter what was probably not such a good idea. The concept was that this promise alone would stimulate, but that forward guidance is a questionable strategy," he said.

The Fed is buying USD120 billion per month and has set interest rates near zero since the start of the pandemic. It has vowed to keep buying bonds until it sees "substantial further progress" toward its price stability and employment goals, and not to actually raise interest rates until said targets have been comfortably achieved.

Policy makers have also emphasized they are going to look through any inflation they see as "transitory," a description that strikes Cochrane as too vague -- and also reminiscent of arguments made during the late 1960s period that preceded the Great Inflation of the 1970s. Back then, Fed officials often described inflation pressures as due to structural factors outside the central bank's control.

Ex-Fed New York Fed President William Dudley recently told MNI he thinks the Fed's built-in decision to delay rate hikes until inflation has already perked up will mean the central bank will have to tighten more than markets expect, perhaps taking rates to as high as 4% or more.

Cochrane also foresees such a danger for the FOMC. "It will have to move more and more abruptly," he said. This, in turn, will take a toll on the credibility of future central bank pronouncements.

"The Fed will likely have to raise before the end of the promise which will make future attempts to promise things look less robust," Cochraine said. "Any policy should adapt to events, but do so in a predictable way."