Wednesday, August 10, 2011

The FOMC: There is good commitment, and there is...

Yesterday's FOMC statement came with some unexpected news, but in retrospect I think we should have seen it coming. Here is the key change in policy:
The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
Thus, the key change is applying a date to the "extended period" language that has been in the statement since late 2008. "Likely to warrant" is about as clear a commitment as I think will ever come from the FOMC. Compare this to what was in the November 2010 statement where QE2 was laid out:
...the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.
That program was executed exactly as planned. There was some language in there to hedge against wild unforeseen circumstances, but once the FOMC gets this specific it has to stick to its guns or risk destroying its credibility.

A key problem here, of course, is that not everyone is on board, and the dissenting group - Fisher, Kocherlakota, Plosser - includes two of the most capable economists on the committee. Outside of Dudley, the New York Fed President, only one of the voting regional Fed Presidents, Evans (Chicago), voted in favor of the policy change. I think the dissenters are on the right side of this issue.

Given the current operating regime the Fed is in, with very large quantity of excess reserves in the financial system, and the interest rate on reserves (IROR) determining short-term nominal interest rates, the experience is not there, nor is there agreement on what theory to apply, for the Fed to understand well what it is doing. It is also very difficult for people trying to understand what the Fed understands, to know what is going on. In this context, how can the FOMC be so certain of itself as to commit two years in advance?

Further, it seems the outcome the Fed would hope for is one where inflation increases, the interest rate on reserves increases commensurately, and the Fed proceeds to sell off assets so as to normalize the state of its balance sheet, with zero exess reserves. Committing to IROR = 0.25 for two years risks two outcomes that seem equally bad (if we believe that 2% inflation is optimal). One is the too-high-inflation outcome: People anticipate high inflation, reserves start to look much less desirable, and the high inflation is self-fulfilling. The other is too-low-inflation: People anticipate low inflation, the reserves look more desirable, and low inflation is self-fulfilling. The first scenario is something that I have been worried about. The second scenario was a concern of Jim Bullard, and Narayana Kocherlakota. I think both are possibilities, i.e. there are multiple equilibria.

Fed officials like to talk about "anchoring expectations." In this circumstance, the kind of FOMC statement that would anchor expectations would be something like: "We anticipate raising the fed funds rate target (actually the IROR target, but what the heck) as observed and anticipated inflation warrants. Currently, we think we are on a path on which inflation will increase."


  1. I interpreted this as them trying to move towards the optimal policy prescriptions of monetary policy in NK models under commitment in the face of the ZLB, namely promising a long period of low interest rates after ZLB stops binding to raise inflationary expectations now, thereby lowering real rates, stimulating the economy, and improving welfare during ZLB.

    So I don't interpret this as them being certain of conditions for the next two years. Rather, they're following the theoretical prescriptions of these models.

    It's also therefore not a surprise to see this group of three, whom I surmise place little weight on these models, disagree vehemently with even a change in language that goes in this direction.

    - C

  2. Well C, Plosser think business cycles are a result of swings in productivity - I guess we just have the mother of all productivity I wonder why he has a view on monetary policy at all...

  3. Why do you think the market doesn't agree with you in your fear of increased inflation?

    Rates are ridiculously low even on government bonds of 10 years?

  4. Lars, I suspect that the main difference between them and the rest of the FOMC is their greater suspicion of nominal rigidities. As a result, they are less likely or willing to interpret decreases in output relative to trend as necessarily inefficient and requiring aggressive policy responses. For example, the fact that these same guys seemed to put much more weight on stories about the reallocation of labor across industries is consistent with the notion that they do not interpret as much of the current output gap as inefficient, and therefore requiring the kind of dramatic policy intervention that alternative views might suggest.

    I'm not saying that's the right view, but simply that one can hold this view without believing that all fluctuations are driven by productivity swings in, say, a simple RBC model.

    - C

  5. "Well C, Plosser think business cycles are a result of swings in productivity - I guess we just have the mother of all productivity I wonder why he has a view on monetary policy at all..."

    If you don't know anything, don't speak publicly. Plosser has never stated anything of the sort, and in fact has written a number of empirical papers identifying the sources of fluctuations. Lars is just bitter low-ranked monkey.

  6. Honestly I think if the Fed had said

    "Currently, we think we are on a path on which inflation will increase."

    I think it would have been greeted with derision by most market practicioners, and many commentators.

  7. 1. It's not clear that the policy decision and the dissents are driven by NK thinking. If you have been reading what Kocherlakota says, or talking to the Minneapolis Fed people, you will know that Narayana is trying very hard to be a NK person.

    2. It's hard to square current observations with the NK story. It looks like real rates are too low (in the sense of reflecting a shortage of safe liquid assets in general), not too high.

    3. I agree that it's nonsense to characterize Plosser as being driven by narrow RBC thinking. It's clear he thinks monetary policy matters. Of course, he also thinks there are limits on what the central bank can do in terms of influencing real aggregate economic activity, particularly under the current circumstances, and I agree with that.

  8. "I think it would have been greeted with derision by most market practicioners, and many commentators."

    Well, you have to try to convince people, right? The Fed's job isn't to agree with "practitioners" and "commentators," or to do what they want.

  9. Stephen, I've been busy putting my two-cents in on Scott Sumner's site, but wanted to chime in here as well just for the sake of saying that I agree wholeheartedly with your criticisms of the Fed's recent move.

  10. Why is too high as bad as too low? The Fed has mostly missed their core target on the low side. They have some room to overshoot.

    Do you have a large inflation bet in the market?

  11. Read my previous post:

  12. SW,

    I looked at the other post. It seems a little like you are driving the care, while looking through the rear view mirror. Doesn't the 5 year TIPS spread, which is at 1.95%, suggest core is more relevant than headline?

    Two other questions, if the Fed had a permanent regime shift of switching from 2% to 4%, what would happen to the economy? What about if the shift is temporary?

  13. "Doesn't the 5 year TIPS spread, which is at 1.95%, suggest core is more relevant than headline?"

    The TIPS yield is calculated from the price of the bond and the promised coupon payments. Then, there is a contingent payment, i.e. there is a stream of payoffs determined by the headline CPI, unadjusted. That does not have anything to do with core inflation. Implicit in the price of a nominal Treasury bond is an inflation premium, determined by what people anticipate inflation to be over the period until the bond matures. Actual headline inflation is of course an imperfect measure of inflation in any case, but if you take the difference between the nominal bond yield and the TIPS yield - what I think you mean by the "spread," that does not have anything to do with core inflation, unless maybe you think core inflation has something to do with policy. Was that what you were thinking?

    "...if the Fed had a permanent regime shift of switching from 2% to 4%, what would happen to the economy? What about if the shift is temporary?"

    Not clear where this would be good or bad. I don't think anyone has calibrated the costs of inflation precisely enough to say exactly what is optimal. The Fed seems to like 2%, as that has roughly been our inflation experience for a long time, and it seems to be OK - no one is complaining. I read in the NYT today that Ken Rogoff was suggesting a temporary period of higher inflation to essentially produce debt forgiveness (of private mortgage debt). This of course has its costs - moral hazard (it's a bailout), and the fact that the holders of Fed liabilities bear the inflation tax.

  14. I only meant that headline and core give different views of what has happened to inflation over the last 5 years. You use that to conclude that there is equal risk that the Fed will miss too high as too low. Taking the Treasury yield and subtracting the TIPs yield gives an estimate of inflation over the next 5 years. That seems to provide evidence that in the future, we can expect inflation to evolve more like core than the more volatile headline numbers.

    I guess in my earlier comment I was assuming that headline would converge to core, thus negating your assumption, "an increase in the relative price of food and energy has persisted since 2005, and there is no good reason to expect that relative price shift to go away," but it's possible that the market is just predicting that both ratios will fall and maintain that relative price shift.