Fed officials hint at further rate-cutting battles

Dallas Federal Reserve President Richard Fisher joined a chorus of hawkish officials this week, warning that high inflation ties the hands of the US central bank.

But Janet Yellen, President of the San Francisco Fed, indicated that the risk of lower growth, not of higher inflation, is her major concern right now.

"Current indicators point to continued anemic growth for at least the first half of this year as well as significant downside risks even to those weak expectations," Yellen told a Certified Financial Analysts of Hawaii economic forecasting dinner.

The domestic consumer, the main engine of US economic growth, is "likely to be pretty hobbled" by a toxic mix of tighter lending standards, falling house prices and a softer employment outlook, Yellen said.

The United States faces the danger of an "adverse feedback loop" in which a slowing economy leads to greater caution on the part of lenders, households and businesses, dragging growth down even more, she said.

"An important objective of Fed policy is to mitigate the possibility that such a negative feedback loop could develop and take hold," Yellen said.

Fisher and Yellen both said that, ultimately, the US economy would dodge recession. But they differed on how dangerous the recent uptick in price pressures would become.

Fisher, speaking in Mexico City, argued that the Fed's aggressive program of rate cuts has put it "ahead of the curve." At this point the Fed must carefully balance a desire to spur economic growth with the need to keep inflation contained, he said.

The FOMC has slashed its benchmark lending rate to 3 per cent from 5.25 per cent since mid-September as growth prospects have weakened. The string of cuts included a 75-basis-point emergency inter-meeting move on January 22.

Financial markets anticipate another rate cut of between 50 basis points and 75 basis points at the FOMC's March meeting. Talk of another inter-meeting cut has arisen after recent very weak economic data.

Fisher dissented from the vote to lower rates by 50 basis points on January 30, preferring that rates be held steady at the levels established on January 22.

Yellen is not a voting member of the FOMC in 2008.

"The Fed has to be very careful now to add just the right amount of stimulus to the punch bowl without mixing in the potential to juice up inflation once the effect of the new punch kicks in," Fisher told the Instituto Tecnologico Autonomo de Mexico.

Yellen said core inflation is running higher than she would prefer, at 2.2 per cent in the year through December. But while the recent trend has been "disappointing," inflation should abate as energy prices slip and more slack is built into the US economy, she said.

"I expect core inflation to moderate over the next few years, edging down to around 1.75 per cent under appropriate monetary policy. Such an outcome is broadly consistent with my interpretation of the Fed's price stability mandate," said Yellen.

A ‘New Normal’

Another Fed official, Atlanta Fed President Dennis Lockhart, said the Fed's rate cuts since mid-September should help stabilise financial markets rattled by a credit crunch and a prolonged housing market slump.

Cash auctions should also help thaw frozen credit markets, where adjustments have been "painful but necessary," he said in a speech in Atlanta.

"So, as we move out of the current turmoil, I see the US markets headed toward a 'new normal,' not a return to normal," Lockhart said.

Fisher's comments, in particular, dovetailed with remarks this week from two other Fed inflation hawks, Philadelphia Fed President Charles Plosser and Richmond Fed chief Jeffrey Lacker.

That suggested a bloc of resistance to the further interest rate cuts that financial markets are expecting.

Fisher said strong demand for commodities from emerging markets has contributed to "unprecedented" inflationary forces that are pushing US prices up.

Still, he acknowledged the US economy was slowing "suddenly and precipitously" as financial institutions pull back from or raise the cost of credit.

Yellen said disruptions in US and global markets have "laid bare some fundamental issues" with the structure of the financial system that will require significant adjustment.

Fisher said he voted against the half-point rate cut last week because he thought that, with worrisome levels of inflation, the Fed had eased borrowing costs enough to hold economic growth risks at bay.