Debate on Fed Likely to Shift to Pace of Increases

With the U.S. October jobs report cementing expectations for a December interest rate rise, the next big fight on the Federal Reserve's policy-setting committee will be over the pace of future increases.

"It is going to be a very hot debate," St. Louis Fed President James Bullard said Friday as he answered audience questions after delivering a speech in his home base. "We certainly said we are going to go gradually. I think there is unanimous support for that on the committee. But what does gradually actually mean?" Bullard votes on policy in 2016.

Investors sharply lifted bets that the central bank will raise the benchmark rate at its Dec. 15-16 meeting after news that employers added 271,000 workers to payrolls, the biggest gain this year. The challenge will be reining in any expectations of a faster pace of tightening than Fed officials themselves foresee.

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One reason for caution is that it could lead to further appreciation of the dollar, whose strength in the last 12 months has already been a drag on U.S. exports and inflation. Following the payroll report, the greenback gained against all of its 16 major peers, while yields on 10-year Treasury notes spiked past 2.30 percent, the most since July, and commodities fell to a 1999 low.

Chair Janet Yellen said in testimony this week that "markets and the public should be thinking about the entire path of policy rates over time," adding that an early start to rate increases would let the committee "move at a more gradual and measured pace."

Maybe not. A series of strong jobs reports and a turn toward faster rates of inflation would challenge officials' assumptions about a gradual pace, said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York and a former Fed economist.

Last month's jobs report "raises questions about the pace of hikes next year," said Feroli. "We're already near full employment, and wages are starting to tick up, so can the pace of hikes really be that gradual? I think it may not be that gradual."

This will be a key challenge for Fed communications, and policy makers are already starting to stake out their positions. Disagreement over pace could lead to a messaging mish-mash that could confuse investors and result in higher-than-necessary borrowing costs should it trigger financial-market volatility.

"We need to think about the rate path," Chicago Fed President Charles Evans said in a CNBC interview Friday. Evans is a voting member of the Federal Open Market Committee this year. "We need to have communication that says the path is gradual."

Missing 'Gradual'

The word "gradual" was not in the statement issued after the Oct. 27-28 meeting of the policy-setting FOMC to describe the projected pace of tightening. If the committee decides to insert such a commitment in December, officials would be going back to a strategy of offering investors explicit forward guidance — or telegraphing future actions on interest rates — which they've tried to avoid in order to make policy more data-dependent.

Feroli said the committee should drop words such as "gradual" that give forward guidance, which he called a relic of the financial crisis, and allow economic data to dictate the pace of tightening.

Over the past year, the committee has used several forms of guidance. Last December, the FOMC said the committee could be "patient" in normalizing the stance of policy, a shift from its pledge to hold rates near zero for a "considerable time." The "patient" phrasing carried through into January and was dropped from the statement in March.

For now, the FOMC's main tool to communicate the pace of future rate rises is a series of quarterly interest-rate forecasts from individual officials, presented in a so-called "dot-plot."

The median dot, according to projections published in September, showed officials expected to raise rates by about 1 percentage point each year to 3.4 percent by the end 2018 from 0.4 percent at the end of 2015. But those forecasts can be quickly overtaken by fresh economic data and are not a commitment of future action, which limits how much information the dot-plot provides to investors.

Donald Kohn, a former Fed Board Vice Chairman who led a central bank panel that examined how to improve communication, said policy makers have to be careful to avoid saying more than they know about the future.

Kohn said the Fed could be more specific about how changes in the economy could prompt officials to speed up or slow the pace of rate increases.

Economic Variables

"Maybe they need to concentrate less on the exact path and more on what kinds of things that they will be looking at," said Kohn, a senior fellow at the Brookings Institution in Washington.

One case in point: the Fed statement in October said "even after" the central bank is near its goals, "economic conditions may, for some time, warrant keeping the target federal funds rate below levels the committee views as normal in the longer run."

Investors could use more explanation about what these hurdles to a faster pace of rate increases are, Kohn suggested.

Gary Stern, a former Minneapolis Fed president who also served on internal committees seeking to improve communications, said the most effective way to talk about the pace would be to have Yellen update the committee's views in her press conferences, which could be held more frequently than at every other meeting as is currently the case.

"Getting the language right is always hard" in the statement, he said. "They have tied themselves in knots over some of this communication."

Ward McCarthy, chief financial economist at Jefferies LLC in New York, said additional guidance is likely to appear in the statement for a while.

"Right now, they are holding our hand to cross the street," he said. "At some point, they are going let us read the traffic lights ourselves."

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