By Steven K. Beckner

(MNI) – As Fed policymakers contemplate the appropriate time to
begin the process of removing their unprecedented monetary stimulus,
they are divided on a key issue: the economy’s growth potential and the
“natural” rate of unemployment.

Few are eager to start the tightening process outside of dissenting
Kansas City Federal Reserve Bank President Thomas Hoenig, who said in
April that the Federal Open Market Committee should move “soon” to begin
pushing the federal funds rate from near zero toward 1%.

Other FOMC members want to wait awhile, but some are more inclined
than others to draw the “extended period” of “exceptionally low” rates
to a close.

One key issue is the size of the “output gap” — the difference
between actual real gross domestic product and potential,
non-inflationary GDP.

When the output gap is negative — when actual output is falling
short of potential — Fed and private economists generally believe there
are less inflation pressures because under-utilization of labor and
other resources, or “slack,” will tend to hold down wages and prices.

Related to the “output gap” is the “natural” or non-accelerating
inflation rate of unemployment (NAIRU).

Despite three quarters of GDP growth, pretty much everyone agrees
there is still a negative output gap and that the economy is far from
“full employment,” i.e. that the current unemployment rate is well above
NAIRU.

The question is: what is the magnitude of the growth and employment
gaps, and how fast are they likely to be closed?

Not even the most dovish FOMC members think the Fed should wait
until the economy returns to full employment (or NAIRU) before it starts
to tighten monetary policy. But since views differ as to just where
NAIRU lies, there is disagreement about how soon the Fed should begin
the tightening process.

While some still believe NAIRU lies as low as 4-1/2%, others are
convinced it is higher — perhaps much higher. At least for the time
being, some officials are convinced that because of the impact of the
financial crisis and the policy response, such as extended unemployment
benefits, the NAIRU may be closer to 7%.

But there is no consensus among policymakers or their advisors that
the NAIRU has risen significantly. The models the Fed uses to help it
determine the appropriate path of the federal funds rate target still
assume that the NAIRU is where it was before the crisis. And that has
important monetary policy implications, although the Fed does not rely
exclusively on such Taylor Rule-type models.

If indeed the natural rate of unemployment is 4-1/2% or
thereabouts, then a near zero funds rate will be appropriate for quite
some time to come, and the Fed should not start tightening to preempt
wage-price pressures until the actual rate of unemployment falls to 8%
or even lower, key Fed officials believe.

But if the natural rate or NAIRU is really more like 6% or even 7%,
then delaying tightening until the actual unemployment rate falls to 8%
or so would be dangerously inflationary, others fear.

Then, sources warn, tightening would come too late to avoid a
deterioration of inflation expectations and a break-out of inflation
itself.

Nevertheless, most officials seem to remain very much on board with
an “extended period” near zero, while emphasizing that period is
contingent upon whether or not there is any change in the conditions
enumerated by the FOMC: “low rates of resource utilization, subdued
inflation trends, and stable inflation expectations.”

Even if the output gap is narrower or NAIRU higher, sources say
that, with the unemployment rate at 9.9% and more than 17% after
allowing for discouraged workers, there is plenty of room for the
economy to grow and create jobs without straining resources and
generating inflation pressures — and plenty of time for the Fed to act.

Those who are inclined to delay tightening also argue that the
Fed’s highly accommodative interest rate and quantitative easing
policies are not causing an inflationary expansion of the money supply.
They note that banks have been unwilling so far to convert unprecedented
amounts of excess reserves into expanded lending.

Fed Chairman Ben Bernanke has continued to cite tight bank credit
along with joblessness as “headwinds” to robust recovery and has been
leaning on banks to make more loans to creditworthy borrowers. He has
been echoed by a number of other officials, both publicly and privately.

Far from fearing an acceleration of inflation, some officials
project further disinflation.

Furthermore, some officials have indicated that fall-out from the
European debt crisis could marginally extend the extended period. But
then, one confided, “I never thought it was about to come to an end
anyway.”

** Market News International Washington Bureau: 202-371-2121 **

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