The Fed Is Searching for a New Framework. New Minutes Show It Doesn’t Have One Yet

Neil Irwin

The quandary facing the Federal Reserve this summer is the same as it was back in the spring, and winter, and last fall: By traditional guideposts like the unemployment rate, it looks as if it is time for the Fed to be raising interest rates. Yet the global economy seems to be locked in a low-growth, low-inflation world in which raising interest rates is at best unnecessary and at worst dangerous.
That tension was on display Wednesday in the minutes of the Fed’s last policy meeting, which raised the possibility of rate increases as early as September.
As is the Fed’s standard practice, the description of the meeting was stripped of names and summarized in bloodless language. But reading between the lines, it is clear there was a rich debate over what factors the Fed should be weighing, and how, in making its next move.
Some policy makers saw evidence that the labor market was getting tighter, the result of which should be higher wages and prices. Others “saw little evidence that inflation was responding much” to the low jobless rate. With inflation low, “many judged it was appropriate to wait for additional information” before considering raising rates.
The result of all that debate at the July 26-27 meeting was affirming the status quo — agreement that “it was prudent to accumulate more data in order to gauge the underlying momentum in the labor market and economic activity” and that “members judged it appropriate to continue to leave their policy options open and maintain the flexibility to adjust the stance of policy based on incoming information.”

    Janet Yellen, chairwoman of the Federal Reserve, continues to face a tricky situation in deciding what to do about interest rates. Credit Charles Krupa/Associated Press       

That continues a volatile year for market perceptions of when, and how much, the Fed might make the shift toward tighter money. At the start of 2016, it seemed nearly certain the Fed would follow up its interest rate increase in December with more of them this year.
Weak growth in the United States and abroad, combined with a volatile first half of the year in financial markets, drove the odds of a rate increase down to 12 percent by July 1, based on prices in futures markets. That had gone back up to 53 percent by Tuesday. (It edged down very slightly, to 51 percent, after the release of the minutes Wednesday.)
In public comments this week, Fed officials have suggested that markets are underrating the possibility of a September rate increase.
“We’re edging closer toward the point in time where it will be appropriate, I think, to raise interest rates further,” the New York Fed president, William C. Dudley, told Fox Business on Tuesday. The Atlanta Fed president, Dennis Lockhart, told reporters that one or two rate increases are possible this year and that economic data would suggest strong consideration of raising rates next month.
The Fed faces a profound question: Is the basic framework it has used over the last generation to set monetary policy the correct one in this moment, or has something fundamental shifted in the global economy that calls for a new one?
If this is just a standard economic expansion that has been slowed by some bad luck, then the central bank’s usual rules apply. That rule book involves examining how close the economy is to functioning at its full potential, and trying to move up and down to keep on that steady path so as not to let inflation get out of control.
But there is plenty of evidence — and a vocal contingent of officials inside the central bank — that the usual way of thinking isn’t quite working.
For one thing, the rest of the world is growing so slowly that it is creating a steady downdraft on inflation and growth that may mean the usual worries about inflation don’t apply. Rising wages for American workers over the last year or so have been counteracted by other forces preventing inflation from taking off, including falling energy prices and slack demand for goods and services from overseas.
Moreover, any step the Fed takes toward tightening the United States money supply seems to be offset by an opposite reaction elsewhere. With other countries easing monetary policy with ultralow interest rates and quantitative easing, small moves to tighten American policies have created outsize rallies in the dollar, which disadvantages American exporters and creates ripple effects through the global credit system.
That has led Fed officials to steadily mark down both their expectations for how quickly to raise short-term interest rate and where those rates will settle in the longer run — meaning they think that low rates may be more a new normal than a short-term aberration.
The San Francisco Fed president, John Williams, raised the possibility this week of more significant change in how the Fed thinks about its goals, even raising the possibility of increasing the Fed’s 2 percent target for inflation, or of the Fed’s replacing its inflation target with a goal for nominal gross domestic product.
The Fed chairwoman, Janet L. Yellen, will have a prime opportunity to elaborate on her own views in this debate next week, in a scheduled speech at the Federal Reserve Bank of Kansas City’s annual economic symposium in Jackson Hole, Wyo.

But for now, Fed officials are openly discussing the need to approach policy choices differently, and holding off from interest rate increases as a result, but not quite concluding that the old rules no longer apply and embracing an alternate approach.
It’s an awkward place for a central bank to be, but until Ms. Yellen and her colleagues can find consensus around what the new framework for monetary policy ought to be — or conclude that the old models still have some usefulness — the uncertainty evident in the July minutes won’t change.

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