By Jason Lange and Jonathan Spicer
WASHINGTON (Reuters) - Federal Reserve policymakers urging caution over interest rate hikes have gained the upper hand in the central bank's internal debate, but the risk for the U.S. economy is that they are wrong to downplay a recent rise in inflation.
In words that echo those of colleagues on the Fed's dovish wing, Fed Chair Janet Yellen told a news conference on Wednesday that "caution is appropriate" when it comes to raising interest rates. She said she was not convinced underlying inflation had accelerated.
If Yellen is right, financial markets have ample warning for the gradual pace of rate hikes she said was likely.
But many private economists buy into the argument by an opposing faction within the Fed that U.S. inflation is indeed stirring.
They point to a range of recent data to back their view, including a reading Thursday showing underlying U.S. inflation rose 2.3 percent in the 12 months through February, the biggest increase in more than three years. The Fed's target is 2-percent inflation.
Faster price gains would likely trigger more aggressive rate hikes which Yellen in the past has warned could cause a recession.
"If we got to a point where the Fed had to raise (rates) quickly, it could be very destabilizing," said Northern Trust (NASDAQ:NTRS) economist Carl Tannenbaum, formerly an economist at the Chicago Fed.
Yellen's comments sounded much like those of a vocal faction of Fed policymakers, led by Governor Lael Brainard, who have argued publicly that the global economic slowdown could knock the U.S. economy off course. Brainard just last week counseled against assuming that a tighter labor market would boost inflation.
However, the chair's assessment that inflation may not yet have turned the corner to a more healthy trajectory runs counter to the view of Fed Vice Chairman Stanley Fischer, who warned this month that faster inflation might well be stirring.
If Fischer is right, Fed Chair Janet Yellen may have to change her tone as soon as the next policy meeting in April.
"Yellen will have a noticeable faction of the committee that's anxious to tighten again," said David Stockton, the Fed's former research director who is now a fellow at the Peterson Institute for International Economics. "They will need to be persuaded that the process is still in place, that this is not an indefinite pause."
DIALING BACK
After Wednesday's decision and fresh forecasts from the Fed that showed most officials prefer just two rate hikes this year, investors and economists dialed back their own rate hike expectations, with traders of interest-rate futures now seeing no rate rise before September.
The Fed raised its benchmark interest rate by a quarter of a percentage point in December, the first time it lifted rates in nearly a decade. Its target now stands as between 0.25 and 0.50 percent.
With the market view for just one rate hike this year at odds with the Fed's view that at least two will be needed, Yellen could find herself in a box particularly if global markets remain relatively calm and threats to the United States dissipate.
"This could reinforce the market’s belief that a dovish Fed is not all that interested in walking the talk, and when the June (Fed) meeting comes around skepticism could still reign” said Scott Anderson, chief economist at Bank of the West.
Some economists, like JP Morgan's Michael Feroli, have even concluded that the Fed is "becoming inherently more dovish," for a number of reasons, including increasing comfort with a tight labor market.
Yellen sought to discount the significance of the slower path of rate hikes suggested by the Fed forecasts, saying they should not be seen as a consensus Fed view.
And she said that the Fed's decision to refrain from noting "downside risks" to its forecasts reflects the fact that global economic headwinds could become tailwinds if easing by central banks abroad successfully stokes growth.
The prospect that inflation could perk up further, Wells Fargo (NYSE:WFC) economist Sam Bullard said, means that "there is risk to the market having just one rate hike priced in."
But overall the Fed's message remained one of patience, even in the face of unemployment at near-normal 4.9 percent and signs of inflation creeping up.
And that suggests that for now, the camp within the Fed advocating a go-slow approach on rate hikes has won the day.