I Dissent (FOMC Edition)

This post was written by Simon van Norden of HEC-Montréal. 

Last week’s FOMC decision to signal looser monetary policy seemed to boost US stocks, as it was designed to. But the decision was a tough one: three of the eleven voting members dissented, which is as high as dissent on that committee has gotten in recent years. In recent years, the dissenters have consistently been the “inflation-hawk” Regional Fed Presidents; this time it was Richard Fisher (Dallas), Charles Plosser (Philadelphia) and Narayana Kocherlakota (Minnesota). I’ve written about Richard Fisher before; he’ll tell you openly that he is one of the weakest economists on the FOMC. You can’t say that about Kocherlakota or Plosser, both of whom are bright men with distinguished research publication records, among other things. (Okay, maybe not as good as those of Peter Diamond, the MIT Nobel Prize winner who Republicans deemed unqualified to serve on the FOMC….but I digress.) So I was interested to understand why they dissented.

Fortunately, Kocherlakota issued a statement explaining his reasons. He puts it this way:

I dissented … because the evolution of macroeconomic data did not reflect a need to make monetary policy more accommodative than in November 2010. In particular, personal consumption expenditure (PCE) inflation rose notably in the first half of 2011, whether or not one includes food and energy. At the same time, while unemployment does remain disturbingly high, it has fallen since November. 

I can summarize my reasoning as follows. I believe that in November, the Committee judiciously chose a level of accommodation that was well calibrated for the prevailing economic conditions. Since November, inflation has risen and unemployment has fallen. I do not believe that providing more accommodation—easing monetary policy—is the appropriate response to these changes in the economy.

Going forward, my votes on monetary policy will continue to be based on the evolution of the data on PCE inflation and its components, medium-term PCE inflation expectations, and unemployment.

Now, that’s generated some comment from Krugman and other blogs, arguing about his particular choice of statistics or dates. But I think that misses two more important points. 

1 - Fiscal Policy:

I think the fiscal policy outlook is different now from what it was in late 2010. There was a news item a week or so ago (was I the only one who heard this?) that the US Congress had decided on new sharp cuts in spending as a condition for raising the debt limit. Many professional forecasters have since lowered their forecasts for US growth and inflation, citing the additional fiscal drag. Some argued this was a major factor behind the subsequent stock market “panic” and a factor in the FOMC decision to change their stance.

Now, Federal Reserve Bank Presidents choose their words very carefully, so it’s worth looking at their statements closely. In his dissent, Kocherlakota mentions fiscal policy nowhere; the words “fiscal” or “debt” or “deficit” do not appear. Also remarkable is his last sentence; his votes will not be influenced by fiscal policy; just inflation and unemployment. Furthermore, he’s not interested in inflation or unemployment outlooks (fiscal policy might affect those indirectly), he’s basing his votes on inflation and unemployment data. I’ve done work on how unreliable forecasts can be, but I would have thought that the August 2^nd vote in the US Congress told us something that changed the outlook for inflation and unemployment. It would not be in the data yet but, because monetary policy needs to look forward as best it can, it should still be potentially important information.

I don’t know why Kocherlakota does not feel that way. Perhaps he feels that fiscal policy doesn’t affect unemployment or inflation. Perhaps he does not think that the debt ceiling vote told us anything that we didn’t know in November 2010. Financial markets think otherwise. Financial markets have lowered the interest rate they charge on US Treasury bonds. Their composite long-term rate, for example, fell from 3.61% on Aug. 1^st to 3.02% eight days later.  (The gap between nominal and real rates also fell.) It looks like they have changed their outlooks for inflation. Perhaps he thinks he knows more than the bond market does.

 2 - Inflation outcomes:

Kocherlakota and the other “inflation hawks” account for most (all?) of the dissents in recent years. It seems reasonable to ask whether, in retrospect, the evidence suggests that the FOMC should have put more weight on inflation risks.

The fed cares most about inflation as it affects Personal Consumption Expenditures (PCE); that can be volatile so they put more weight on its “core” (i.e. less volatile) components.

 

The graph above shows those inflation outcomes as well as core CPI inflation. All have been under 3% since late 2008; the core measures have been steadily below 2% and moved above 1% only in the past year. That doesn’t seem to support the inflation hawks’ repeated inflation warnings. (And that’s ignoring the unemployment component of the Fed’s mandate.)

 

FOMC decision

Comments

[Stephen Gordon]

No-one ever seems to notice the disclaimers, so I'll just use the first comment to repeat that this post was written by Simon van Norden.

[Lord]

Or the European mess.

[Paul Friesen]

I couldn't agree more. What inflation there is in the U.S. economy is driven by rising commodity prices which, in turn, are driven by demand in emerging countries. We desperately need some fiscal stimulus here, but politically, all signs point the other way. All the same mindless balance-the-budget opinions that ruled in the 1930's and prolonged the depression for 10 years are back in the driver's seat and I don't see an end to that. This is looking like a long, long, slump.

[Ross Hickey]

What is the fiscal theory of monetary policy that implies that the fed should react to changes in government bond yields? I understand this measure being part of the equation as a measure of expected inflation, but that is only in equilibrium, no? With the wild swings in global markets I think it's difficult to make these inferences in the short run. Another question: did markets react as they did to the news because the interest rate was inappropriate, or was their reaction independent of the interest rate? If the latter perhaps markets have priced things correctly given the lack of political will to fix the fiscal and regulatory problems in the US.
Here is a recent take on how things are unfolding:
http://www.reuters.com/article/2011/08/17/markets-bonds-idUSN1E77G0H020110817
I think it's too soon to say whether Kocherlakota got it right or not. I guess we'll have to wait to see how much unemployment drops in the coming months? Let's hope we get less bad news as the Fed continues to run out of slack to accommodate our worries.

[Simon van Norden]

Ross Hickey: The "textbook" treatment of financial markets argues that they reach equilibrium in minutes; that would imply that the bond prices I mentioned above fully incorporate all the news from these FOMC decisions (plus everything else that happened in the meantime.)

I mention bond yields only to indicate that (a) financial markets seemed to think that there was important information in the debt-ceiling decision, and (b) that they do not seem concerned about US inflation risks.

I think you're also missing the point. The question is not whether Kocherlakota got it right. The question is how seriously to take his dissent. Right?

[Ross Hickey]

I likely missed the point, because we appear to be on different pages. Interesting post! Thanks.

[Too Much Fed]

Price inflation targeting (and I believe NGDP targeting will end up the same way) both suffer from the same problem. They ignore medium of exchange, specifically too much currency denominated debt.

[Kevin]

I am no expert on this. Can someone please explain why there wouldn't be some benefit in a looser monetary policy in terms of this large debt. For instance, in the past, nations (including the US) have used inflation and loose monetary policy to help pay down their debt. The inflation hawks seem only interested in one parameter. Not only are there inflation vs. unemployment issues, but there is also the consideration of the massive deficit. As well, loose monetary policy could weaken the dollar against competitors (not China if they keep their peg. This, theoretically, could lead to stronger exports, which could be extremely helpful in growing the economy.

[Kevin]

p.s.

I understand there will be those hurt by higher inflation. I.e. people on non-indexed fixed income, bond holders, etc. However, it is still possible that the two points I brought up (deficit reduction in real terms and exchange rate depreciation) could be beneficial on the whole. Worthy of at least being part of the calculation?

[Simon van Norden]

Kevin: I'd say you've got it about right.