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Insight - New agonies, alliances as U.S. Fed debates post-liftoff plan

By Jonathan Spicer

NEW YORK (Reuters) - Federal Reserve officials, who are expected to raise interest rates next month, are already sketching out positions for a post-liftoff debate that may blur the lines between inflation "hawks" and "doves" and make the Fed's policy less predictable.

With unemployment steadily falling, Fed policymakers have been waiting for a return of healthy price and wage increases. But those have yet to appear, prompting some within the central bank to begin doubting whether their tried and tested economic models still work.

Fed officials' private and public comments show that the debate now centres on whether the U.S. economy is returning to its old robust self, or whether tepid growth and resulting weak inflation and slow wage increases have become the new norm after the deep recession of 2007-2009. The Fed's 17 policymakers are also wide apart on the question how high interest rates should go and how quickly to get there.

The debate will effectively determine how far U.S. rates will diverge from those in other major economies that are still in an easing mode and how far the dollar may rise, possibly triggering an emerging markets sell-off and hurting U.S. exports.

Uncertainty as to who will prevail in the debate may also sow confusion among investors, adding to market volatility.

Now even some of the hawks, who would typically worry more about inflation risks than weak economic growth, are weighing a possibility that they may face a long spell of sub-par growth and low inflation. Others, such as Fed Chair Janet Yellen, have held to a tried and true approach of trying to preempt any pick up in prices, which they anticipate next year.

"Some of our fundamental assumptions about how U.S. monetary policy works may have to be altered," St. Louis Fed President James Bullard, a hawk, told a conference this month.

Reflecting such doubts, minutes from the Fed's Oct. 27-28 meeting showed that even as they geared up for a first rate rise in a decade several officials felt it would be prudent to plan for other ways to stimulate the economy if low rates become entrenched.

Those in the more orthodox camp like Fed Vice Chair Stanley Fischer, say a 5 percent unemployment, close to its long-run average, makes them pretty confident inflation will return to the Fed's 2 percent target, especially if oil prices stabilise.

Others worry that the U.S. economy is not behaving in a familiar way in an increasingly complex world where weakness elsewhere threatens to spill quickly into the United States. They advocate keeping borrowing costs low until the Fed better understands how price expectations are formed in the wake of the deep recession, and amid demographic changes and technological breakthroughs.

The battle lines overlap, to an extent, with those dividing hawks and doves in the past. They are not identical, though.

For example, William Dudley, the dovish head of the New York Fed, and Bullard both expect inflation to rise towards target by the end of next year, sooner than forecast by the majority of their colleagues.

Differences in their inflation outlooks and the degree of confidence in the predictive power of relationships between jobs, wages and prices, are reflected in the Fed policymakers' predictions.

Their September forecasts for the central bank's key rate range from less than zero to 3 percent by the end of next year, and from 3 percent to 4 percent in the long run.

Yellen, Fischer and others at the Fed insist that any tightening is likely to be gradual. Policymakers acknowledge, however, that they have yet to agree what gradual means and this uncertainty has been reflected in increased volatility in short-term Treasury markets in recent months.

TRAIL OF TEARS

Fed policymakers say confidence that inflation will rebound should be enough to pull the trigger on rates for the first time, most likely at their Dec. 15-16 meeting. The second move may need more proof that prices are in fact rising, so its timing will offer a better clue to how the tightening cycle will unfold.

It may also show to what extent the Fed still relies on the theory of an unemployment-inflation trade-off commonly known as the Phillips curve.

"You hear arguments inside and outside the (Fed's policy) committee that in this circumstance you should just look at inflation by itself," Bullard, who will vote on rates next year, said. "Maybe it is the appropriate thing to do in this environment,(but)if we are really going to give up on the Phillips Curve at the heart of central banking that would be a major change," he told Reuters from his St. Louis office.

San Francisco Fed President John Williams, a Yellen ally, argues there is a "strong case" for a December rate rise. But he has warned that declining estimates of neutral rates - those that neither accelerate nor slow the economy - are a "red flag" that the economy could have become more vulnerable.

The very fact that the Fed is debating a tightening while Europe, Japan and China continue monetary easing, is giving some policymakers, such as Fed Governor Lael Brainard or Chicago Fed President Charles Evans, a pause.

One fear is a repeat of what happened to the European Central Bank and Sweden's Riksbank. Both raised rates in 2011 because of inflation concerns only to reverse those the following year when a nascent recovery went into reverse.

"We have had different points in time since the downturn where certain regions of the world thought they could de-link against the rest of the world," Evans said this month. "There's often a trail of tears that follows that hope that their own area is stronger."

(Additional reporting by Howard Schneider and Ann Saphir; Editing by David Chance and Tomasz Janowski)