Is there a rebellion at the Federal Reserve?

Photo / AP

Opinion

Zero interest rates might be around awhile longer.

That, at least, was the message last week when two Federal Reserve governors said they didn't think they should raise rates this year. For a consensus-driven institution like the Fed, that could be enough to put its plan to do so on hold. And yes, that was the plan.

Just last month, Fed Chair Janet L. Yellen said that she thought they should start increasing interest rates by December, because it wouldn't be long before inflation started rising toward its 2 percent target. Fed Vice Chair Stanley Fischer agreed. But the doves, who want to wait a little longer, have asked a simple question: Why should they be confident that inflation actually will go up when it shows no sign of doing so?

Now, it might sound strange to worry about inflation being too low, but it's not.

When prices don't go up enough, it's harder for the economy to bounce back from a bust. Why? Well, anytime a shock hits the economy, three things happen. First, companies that aren't as profitable as they thought they'd be need to cut costs -- that is, wages -- by laying people off. (Bosses prefer to preserve whatever morale they can by giving some people a pink slip rather than everyone a pay cut.)

Second, households and businesses that borrowed a lot need to cut their spending on other things to pay back what they owe. And third, the Fed has to cut interest rates to try to keep this from turning into a vicious circle where higher unemployment makes people spend less, which, in turn, makes unemployment worse.

Inflation makes this a little less bad. It effectively cuts wages, debts and interest rates in addition to whatever else has been done. Think about it like this. A company can cut wages by not cutting them if it lets inflation make those wages worth not quite as much. That means businesses don't have to fire as many people during a downturn, households don't have to set aside as big a chunk of their money to pay back what they owe, and the Fed doesn't have to cut rates as much as it otherwise would. This last part is particularly important because the Fed's bond-buying does not seem to work as well as its rate-cutting.

The problem is that total inflation is just 0.3 percent.

Now, it's true, as Yellen has argued, that a lot of this should be "transitory." Oil and import prices have both had what should be one-time drops that fade away in the next few months. Even then, though, that still leaves a lot that isn't so temporary. Core inflation, which strips out volatile food and energy prices to give us a better idea of future inflation, is also a lot lower than we want, at 1.3 percent. So why should we expect it to go up soon? Well, Yellen thinks the fact that unemployment is so low means that inflation can't help but start going higher. This relationship between the two, which has held steady outside of the 1970s, is what economists call the Phillips curve. The question, then, is whether we should believe in it now.

Maybe not.

If you think that inflation won't go up until wages do, and that won't happen until unemployment is even lower than it is now, then you want to wait who knows how long.

Fed governor Lael Brainard says that "the classic Phillips curve influence of resource utilization on inflation is, at best, very weak at the moment." And Fed governor Daniel Tarullo concurs that "under these circumstances, it's probably not wise to be counting so much on past correlations, things like the Phillips curve."

The problem is there is still so much "shadow unemployment" -- people who can find only part-time jobs and not the full-time ones they want, or who have taken a break from looking -- that 5 percent unemployment today might be more like 7 percent unemployment in the past when it comes to wage and price increases. Yellen has made this point plenty of times but seems to have put less emphasis on it the last few months.

This disagreement might not sound that big, but the implications are. If you think low unemployment means that inflation must go higher, then you don't want to wait until inflation actually shows up to start raising rates. Instead, you want to increase interest rates as if inflation had already increased, since that is baked into the economic cake. But, on the other hand, if you think that inflation won't go up until wages do, and that won't happen until unemployment is even lower than it is now, then you want to wait who knows how long. You don't want to take your inflation on faith. You want to see it. Or, as Tarullo put it, you want to find "some tangible evidence of, for example, hiccups in wages or inflation that allow us to make informed decisions based on the evidence." This is a direct repudiation of Yellen and Fischer's logic for preemptive rate hikes.

It is a mutiny of the doves, couched in terms as unexciting as possible.