How much leeway does Fed Chair Janet Yellen have in her campaign to hold interest rates low for a considerable period after asset purchases end later this year? If you listen to Fed hawks, you would believe that she is quickly running out of room. Dallas Federal Reserve President Richard Fisher argued that the liftoff date for interest rates is creeping forward. From Reuters:

"I think the committee, as I listen to them and I can only speak for myself around that table during two days of discussion, is coming in my direction, so I didn’t feel the need to dissent,” Dallas Federal Reserve Bank President Richard Fisher said on Fox Business Network. "We are going to have to move the date of liftoff further forward than had been projected the last time we issued the 'dots'” he said, referring to the official Fed forecasts for short-term interest rates, last issued in June.

At the time of the June FOMC meeting, the most recent read on the unemployment rate was 6.3% (May), while the July rate was just a nudge lower at 6.2%. The inflation rate (core-PCE) at the time of the June FOMC meeting was 1.43% (April), compared to 1.49% in June. So the Fed is arguably just a little closer to its goals, but enough to dramatically move forward the dots just yet? Not sure about that, but a downward lurch of unemployment in the next report would likely elicit a reaction in the dots. If the dots don't move, Fisher promises a dissent at the next FOMC meeting.

The pace of the tightening, however, is in my opinion more important than the timing of the first rate hike. Richmond Federal Reserve President Jeffrey Lacker argues that the pace of rate hikes will be more aggressive than currently anticipated by market participants. Via Craig Torres at Bloomberg:

Investors may be underestimating the pace at which the Federal Reserve will raise interest rates over the next two years, said Jeffrey Lacker, president of the Federal Reserve Bank of Richmond. Short-term interest-rate markets have for months priced in a slower tempo of increases than policy makers themselves forecast. That’s risky because the misalignment, a bet against a rate path that the central bank alone controls, could lead to volatility if traders have to adjust rapidly, Lacker said. “When there is that kind of gap, it gets your attention,” Lacker, a consistent critic of the Fed’s record easing who votes on policy next year, said in an Aug. 1 interview at his Richmond office overlooking the James River. “It wouldn’t be good for it to be closed with great rapidity.”

How much should we listen to Lacker? Torres notes correctly that Lacker's track record on policy is not exactly the greatest:

Lacker’s forecasts haven’t always been on target, which he’s acknowledged in his speeches. In a March 2012 dissent, he indicated the federal funds rate would have to rise “considerably sooner” than late 2014 “to prevent the emergence of inflationary pressures,” according to minutes of the meeting. The benchmark rate is still close to zero, and inflation is below the Fed’s target.

ISI's Krishna Guha suggests that the market expects that Fed Chair Janet Yellen's forecast will win the day. Via Matthew Boes:

"The market now appears to be tracking a guesstimate of the 'Yellen dot' rather than the median"—ISI's Krishna Guha pic.twitter.com/rhlox9dJe3 — Matthew B (@boes_) August 4, 2014

Where to begin? First, it is worth dispensing with the myth of "immaculate inflation." Fed hawks seem to believe that low unemployment is sufficient to send inflation screaming higher. They see the 1970s under ever carpet, behind every closet door. But the relationship between unemployment and inflation is simply very weak:

Generally, inflation has been within a range of 1.0% to 2.5% since the disinflation of the early 1990s. No immaculate inflation. What is missing to generate that immaculate inflation? Inflation expectations. After the decline in inflation expectations in the early 1980's:

inflation expectations have been remarkably stable:

As long as inflation expectations remain anchored, immaculate inflation remains unlikely. Stable inflation expectations thus clearly give Yellen room to pursue a less aggressive normalization strategy. Note that this does not mean waiting until inflation expectations begin to rise before tightening. Remember that the reason that inflation expectations remain anchored is because the Fed does in fact tighten policy in when conditions point toward above-target inflation. The Fed learned in the early 1980s that they do in fact have substantial control over inflation expectations, and they intend to retain that control. But without conditions that argue for a real threat to those expectations - including, notably, actual inflation above the 2.25% in the context of faster wage growth - Yellen will have justification to resist an aggressive pace of tightening.

Moreover, Yellen still has tepid wage growth on her side. And if unemployment dips below 6% as seem inevitable by the end of this year, I suspect we will move into a critical test of the Yellen hypothesis. Consider the relationship between wage growth and unemployment:

The downward slop looks obvious, but becomes even clearer if we isolate some of the movement associated with recessions:

At the moment, wage growth is on the soft side of where we might expect given the unemployment rate, consistent with Yellen's position. If that situation continues, then it follows that Yellen will have a strong hand to play with the FOMC. Lack of wage growth by itself would argue for a very gradual pace of rate hikes even in the face of higher inflation. Yellen - and the majority of the FOMC - will not see a threat to inflation expectations at the current pace of wage growth.

Bottom Line: At the moment, we are focused on wages as the missing part of the higher rate equation. But that is too narrow of an analysis. Also on Yellen's side is low actual inflation and anchored inflation expectations. To be sure, the Fed will be under increasing pressure to begin normalizing policy if unemployment drops below 6%. At that point the Fed will be sufficiently close to their objectives that they will believe the odds of falling behind the curve will rise in the absence of movement toward policy normalization. But without a more pressing threat to inflation expectations from a combination of actual inflation in excess of the Fed's target and wage growth to support that inflation, Yellen has room to normalize policy at a gradual pace. For now, the data is still on her side and the hawks will remain frustrated, much as they have for the past several years.