Will the Fed's New Hawks Force a Change of Course?

Fed Chairman Ben Bernanke
Fed Chairman Ben Bernanke

The arrival of a number of inflation hawks on the Federal Reserve's interest rate-setting committee raises a question: Is monetary policy is about to be toughened from its current easy stance?

The Federal Open Market Committee (FOMC) is meeting Tuesday and Wednesday for the first time in 2011 and will issue a statement after Wednesday's session. And while most analysts don't expect a major departure from the last Fed meeting in December, the voting lineup has changed substantially.

The voting members now include Charles Plosser, president of the Philadelphia Federal Reserve, and Richard Fisher from Dallas, who both have expressed qualms about the Fed's decision to buy $600 billion in government bonds last November. In addition, Narayana Kocherlakota of the Minneapolis Fed is thought to be against the program, known as quantitative easing. Gone is Thomas Hoenig of the Kansas City Fed, who also opposed Fed Chairman Ben Bernanke's efforts to stimulate the economy.

The three newcomers can cast dissenting votes, but they can't block the bond-buying program from going forward. However, an open rebellion could rattle the financial markets.

"A More Hawkish Tilt"

"There is no question that the large-scale asset purchases are not uniformly embraced within the Fed. There are definitely differences of opinion about it," says Josh Feinman, global chief economist for DB Advisors, Deutsche Bank's institutional asset management business.

"But Bernanke and most of the people on the Fed are committed to this and will see this through to June, when they announce it will end," Feinman says. He thinks the Fed will then reassess the economy based on current data and decide whether to press ahead with another round of buying Treasury bonds.

Other analysts agree. "On the whole, the new voters appear to have a more hawkish tilt than their predecessors, but the votes that will count are that of the Fed chairman and his new vice chairman, Janet Yellen," wrote Mark McCormick, currency strategist at Brown Brothers Harriman in New York. He classified Yellen, former head of the White House Council of Economic Advisers under President Bill Clinton, as a "moderate dove."

Core Inflation Is Weak

Concerns have been raised that the quantitative easing program could unleash a wave of runaway inflation. Prices in China and Brazil have skyrocketed recently, and the worry is that their inflation will be exported back to the U.S. in the form of higher prices for consumer goods.

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As a result, inflation hedges such as gold and silver have soared in the last year, and the difference between the interest rate paid by inflation-protected Treasurys and regular Treasurys has widened, indicating higher inflation expectations ahead.

But so far, those concerns have not shown up in the statistics. While the consumer price index rose 0.5% in December, its largest monthly gain since June, 2009, so-called core inflation (minus food and fuel) was a relatively weak 0.1%. For the year, core inflation was only 0.8% in 2010, well below the Fed target of 2%.

The Europeans don't share the Fed's lack of concern about inflation. Jean-Claude Trichet, the head of he European Central Bank, says he doesn't believe the core inflation number was a good predictor of future price rises. "All central banks, in periods like this where you have inflationary threats that are coming from commodities, have to be very careful that there are no second-round effects on prices," Trichet recently told The Wall Street Journal.

Employment's Hard Road

DB Advisors' Feinman says he believes the economy is recovering slowly -- not a "gangbusters recovery, but at least a better recovery than we've been having" -- and that the labor market will begin creating around 200,000 jobs a month.

Still, that doesn't mean there will be a quick end to the economic pain. Feinman says at the current rate of job creation, it would require 11 million new positions just to get back to the unemployment rate – 4.5% -- that prevailed before the financial crisis began in 2007. That reality won't change no matter who's casting votes at the FOMC meeting.