Two Fed officials offer different views on risks from low rates

(Bloomberg) – Two Federal Reserve officials laid out sharply different takes on whether continued low interest rates might raise the risks of financial instability, highlighting divisions on the Federal Open Market Committee ahead of its September policy meeting.

Federal Reserve Bank of Chicago President Charles Evans argued at a conference in Beijing Wednesday that expectations for interest rates remaining low for a long time are becoming entrenched among investors, allowing the Fed to delay raising rates without running the risk of causing financial instability.

"Long-run expectations for policy rates provide an anchor to long-run interest rates," Evans said in the text of his prepared remarks. "So, lower policy rate expectations act as a restraint on how much long-term rates could rise following a surprise over the near-term policy path."

Speaking at the same conference, Boston Fed President Eric Rosengren warned that high commercial real estate valuations in the U.S. represented a risk to the banking sector in the event of an economic shock.

"One could envision a scenario where commercial real estate prices could decline significantly if underlying rents, occupancy rates and market interest rates become less favorable," he said, according to prepared remarks. "Such a revaluation, in conjunction with an economic downturn, could make a recession worse than it would have been had policymakers normalized interest rates more rapidly."

Two Camps

The central policy debate facing the FOMC involves whether the Fed needs to raise rates before inflation hits its 2 percent target in order to reduce the risks of either creating financial bubbles or overshooting on inflation. Either outcome could force the central bank to subsequently raise rates quickly, potentially pushing the economy back into recession.

Investors see a roughly 34 percent probability of a quarter percentage point rate rise at the FOMC's Sept. 20-21 meeting, according to pricing in federal funds futures.

Rosengren, who has long favored keeping rates low in order to spur job creation, has swung his concerns toward financial stability as employment, now at 4.9 percent, has approached what most economist believe is its lowest sustainable level, while inflation has gradually risen.

'Not Without Risks'

"The Federal Reserve's dual mandate — stable prices and maximum sustainable employment — is likely to be achieved relatively soon," he said. "By slowly normalizing rates, we would hope to continue to support growth. However, keeping interest rates low for a long time is not without risks."

Evans, on the other hand, is among policy makers who remain skeptical that low unemployment is doing much to push inflation back toward the Fed's 2 percent target.

Evans cited recent meetings with executives in the life insurance industry to advance an argument that he and his colleagues should wait to raise interest rates until inflation has reached 2 percent. Their preferred measure has been below that target for more than four years, and Fed staff estimate it will remain so for at least another two years.

The Chicago Fed chief said the investment executives he met "are reassessing the yield-curve environment and increasingly coming to the view that persistently slow output growth in the U.S. and abroad may keep real interest rates low for a long period of time; longer than they likely thought one, two or certainly three years ago."

The rate-setting FOMC has voted to leave interest rates unchanged so far this year following a rate hike in December that was the first in nearly a decade. While continually signaling a desire to lift rates, Fed officials have been delayed by concerns over global growth and surprise events, like Britain's vote to exit the European Union.