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Tug of war at the Federal Reserve

Although many Americans may not be aware of it, there is a debate between two factions within the Federal Reserve over policies that will affect the future course of everything from mortgage interest rates to the price of gasoline to stock market returns to interest rates on savings accounts.

The release of the minutes from the January 24-25 monetary policy meeting at the Fed highlighted the divide on the central bank's rate-setting committee. On one side are the "doves," who would like to ease monetary policy further to try and bolster the recovery. At the very least, this group would like to push forward with the current commitment to keep interest rates at near-zero levels through the end of 2014.

On the other side of the debate are the "hawks" on the committee, who would like to begin tightening policy with interest-rate hikes as soon as possible.

Why can't the two sides agree on the direction rate-policy should take? One problem is that the Fed is in unknown territory. It's quantitative easing policies to date have pushed far beyond anything that has ever occurred in the past. Thus, there is no precedent to turn to when assessing the inflation risks these policies have created.

The uncertainty over risk leaves room for disagreement. Hawks believe inflation risks are high, while doves believe they are low. The doves seem to have the better argument. Presently, the Fed is running below its stated inflation target and financial markets do not appear to be concerned with the longer run inflation outlook. The yields on long-term Treasurys, for example, remain historically low, indicating the bond market isn't expecting much in the way of future inflation.

Additionally, the Fed has a new tool to fight inflation that didn't exist in the past -- the ability to raise the interest rate it pays banks for holding reserves (raising this rate gives banks an incentive to hold reserves instead of lending them out, and so long as the reserves remain in banks, they don't create inflation).

When it comes to the size of the benefit of further quantitative easing the roles are reversed. Hawks do not see much benefit from further easing while doves see much larger benefits (this difference is driven mainly by the use of different models to evaluate policy).

For now, it's a standoff. There aren't enough doves willing sign on to further easing -- that won't happen unless there is unexpected negative news about the recovery -- and there aren't enough hawks to move policy in the other direction. Thus, further easing is very unlikely unless there is bad news about the economic outlook. The Fed's meeting minutes made that clear.

What about tightening? If the recovery continues, or picks up pace, the doves may not be able to hold off the hawks. The hawks have never liked the commitment to keep interest rates low through 2014, and if there is any sign of inflation before then, they will push hard to alter course. Central bankers have, as a group, a very high dislike for inflation and if prices tick up as the recovery proceeds, the hawks could gather more votes. But I don't think this will happen. In my view, it would damage the Fed's credibility to break its commitment to keep rates low through the end of 2014 -- but I certainly can't rule it out either.

So I believe the most likely outcome is that the Fed will live up to its commitment to keep rates low through 2014. But if they don't -- if the struggle on the committee turns in the hawks favor -- that would mean higher interest rates sooner rather than later.

If interest rates do go up (and they will some day), the question is when -- and whether that would be good news or bad news for the economy. If interest rates go up too soon -- before the economy has recovered sufficiently -- that's bad news, as it would slow the recovery. But if interest rates are increasing because we've recovered and returned to full employment, that's a different story. A return to full employment, at long last, would be welcome news, indeed.

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