Federal Reserve's primal divide: Is economy overheating or stuck in a rut?

[ST LOUIS] Investors may be expecting a US interest rate increase in December, but Federal Reserve policymakers remain divided over whether the economy is mired in a rut, strong enough to withstand an immediate hike or hovering somewhere in between.

Speaking in the wake of the US central bank's decision last week to hold rates steady, 10 Fed officials fanned out for appearances this week that emphasized the profusion of"Fedspeak" that markets and the public are trying to digest.

The Fed raised rates last December for the first time in nearly a decade, and many investors currently expect it to do so again this coming December - but only at a narrow 52 per cent probability, according to data from CME Group.

With a potentially volatile US presidential election and two months of economic data still to come, the Fed policymakers'remarks suggested the debate is far from over.

"The low interest rate environment is not just a US phenomenon, or simply a situation engineered by Federal Reserve policy," Chicago Fed President Charles Evans said in a speech to a community banking conference in St Louis on Wednesday. "Rather, it is a global phenomenon with underpinnings in economic fundamentals" that are likely to persist.

Two states eastward, in Ohio, Cleveland Fed President Loretta Mester in contrast said it was a mistake to think "this time is completely different," and discard the standard practice of raising rates well before inflation rises.

"Policymakers...should not throw out all that's been learned from past experience or be led astray by thinking this time is completely different," Ms Mester said in her first remarks since she dissented against last week's decision and argued for an immediate rate hike.

She emphasised the Fed's credibility on communications was at stake if the central bank was not systematic in how it reacts to economic conditions and warned against a too-cautious approach given the Fed's progress on jobs and inflation. "Status quo is always attractive. If we wait to every data point lines up, we surely will get behind the curve," she told reporters following her speech.

Towards the middle, San Francisco Fed President John Williams said on Tuesday that the risks of waiting any longer to raise rates are growing.

On Wednesday, Minneapolis Fed President Neel Kashkari said that rates could stay low for longer because there are no signs of inflationary pressures. "The economy still has room to run before it overheats," Mr Kashkari said at the Institutional Investor Conference in Minneapolis, which was streamed live on the bank's website.

Other regional Fed presidents and Fed Governor Jerome Powell are due to speak on Thursday.

The most influential voice, Fed Chair Janet Yellen, has kept her options open, saying she feels the case for a rate increase is strengthening, but also making the open-ended statement last week that the economy still had "room to run" on job creation.

She testified before the US House of Representatives Financial Services Committee on Wednesday in a hearing that dealt largely with the Fed's regulatory role and changes it is considering to its annual stress tests for banks.

FUNDAMENTALLY SLUGGISH

Mr Evans' comments highlighted the Fed's dueling visions over where the economy stands eight years into a sometimes sluggish recovery.

Along with Ms Mester, two other regional Fed presidents dissented on last week's rate decision, and others have cited the need for the Fed to act in time to prevent any rapid run-up in inflation.

The competing body of thought, with strong adherents within the Fed's more influential, Washington-based board of governors, argues that the global and US economies have become fundamentally sluggish in the wake of the 2007-2009 financial crisis.

Mr Evans said weak growth, an aging workforce and poor productivity may leave the US economy stuck with low interest rates for years to come, and the Fed struggling to reach its 2 per cent inflation target.

As some in the financial industry press for higher rates to improve their lending margins, Mr Evans offered a sobering counterpoint: It's not likely to happen fast.

The steady decline in estimates of equilibrium interest rates, Mr Evans said, means monetary policy is not as loose as many analysts estimate, there is less risk of inflation rising too fast - and less reason to move the policy rate higher.

"US policy today is less expansionary than what is often calibrated from simple monetary policy rules or other historical comparisons," Mr Evans said. "The risk of overshooting our 2 per cent inflation is lower - and the likelihood that we actually get to 2 per cent is smaller."

Mr Evans told bankers they may need to plan carefully for a"new normal" of low rates, rather than hope for the return to an era when a larger gap between deposit and lending rates gave them more flexibility to compete. "We will likely be in a low interest rate environment for some time," Mr Evans said. "This is one reason monetary policy is expected to normalise at a very gradual pace."

REUTERS