Inside the FOMC – it is all chaos out there

Narayana Kocherlakota’s recent speech is titled as — Inside the FOMC. He says when elected as President, people congratulated but also asked him what would you do? 🙂

As you just heard, I became president of the Federal Reserve Bank of Minneapolis last October. Here’s the start of a rather typical conversation that I would have had with my friends and relatives last fall. “Congratulations! That’s fantastic. Now, what is it that you will do exactly?”

As it turns out, the job has a lot of interesting aspects. But I think I’ve been invited to speak here today because I help formulate monetary policy for the United States. So what I plan to do is give you some feel for how this part of my job works. In doing so, I’ll highlight the Federal Reserve’s quintessentially American structure. Unlike the central banks of other countries, you’ll see that ours is specifically designed to draw upon the insights of small town businesses, farmers and ranchers, and large manufacturers, among others, to formulate monetary policy. Before I proceed, I must remind you that any views I express here today are my own, and not necessarily those of others in the Federal Reserve System.

What do I mean by an American structure? Well, relative to its counterparts around the world, the U.S. central bank is highly decentralized. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts. The Ninth District is, by area, the second largest. It includes Montana, the Dakotas, Minnesota, northwestern Wisconsin, and the Upper Peninsula of Michigan.

Eight times per year, the Federal Open Market Committee—the FOMC—meets to set the path of short-term interest rates over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board contribute to these deliberations. (Actually, right now, there are only five governors—two positions are unfilled, and we’re scheduled to go down to four by the end of the month. The good news is that the White House has nominated three excellent candidates for the three vacancies.) However, the committee itself consists only of the governors, the president of the Federal Reserve Bank of New York, and a rotating group of four other presidents (currently Cleveland, St. Louis, Kansas City, and Boston). I’ll be on the committee in 2011.

In this way, the structure of the FOMC mirrors the federalist structure of our government. Representatives from different regions of the country—the various presidents—have input into FOMC deliberations. The input from the presidents relies critically on information they receive from their districts about local economic performance. We obtain this information through the work of our research staffs—but we also obtain it from business leaders in industries and towns, in my case, across the Upper Midwest. The Federal Reserve System is deliberately designed so that the residents of Main Street are able to have a voice in monetary policy.

He then discusses a typical FOMC meeting:

So how, exactly, do the FOMC meetings work? In the remainder of my remarks, I’ll take you inside an FOMC meeting. Its structure provides a perfect vehicle to communicate the key considerations confronting monetary policymakers in the United States today.

The typical FOMC meeting features two so-called go-rounds, in which every president and every governor has a chance to speak without interruption. The first go-round is referred to as the economics go-round. The meeting participants describe their views on current economic conditions and their outlook for future economic conditions. The presidents’ remarks will typically include references to their own local economies, as well as the national and global situation.

For a more detailed outlook one should read this superb speech from Lawrence Meyer.

Ok now to the main part of the post. On reading the speech of Kocherlakota you might feel all is well within FOMC. Well it is not. Lately, there has been number of speeches by Fed policymakers and it is really chaotic. There is disagreement not just over course of economy but also on policy actions needed.

  • Kansas Fed chief Hoenig says economy is on a gradual recovery mode and Fed needs to raise rates. This will help prevent future bubbles and risk taking.
  • St Louis Fed Bullard says (see my post here) Fed’s language to keep rates low for an extended period could actually lead US to become Japan kind of economy. A better solution is Fed should buy more treasuries
  • Minneapolis Fed chief in above mentioned speech says markets have misunderstood Fed policy action.

The FOMC’s decision has had a larger impact on financial markets than I would have anticipated. My own interpretation is that the FOMC action led investors to believe that the economic situation in the United States was worse than they, the investors, had imagined. In my view, this reaction is unwarranted. The FOMC’s decisions were largely predicated on publicly available data about real GDP, its various components, unemployment, and inflation. I would say that there is no new information about the current state of the economy to be learned from the FOMC’s actions or its statement.

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.

That sounds easy—but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.

  • Dallas Fed chief Richard Fisher feels monetary policy cannot do much given current situation.
  • You will get to hear more views in upcoming Kansas Fed’s annual symposium where all chief policymakers and economists get together.

Meanwhile, there is a very interesting article by Joe Hilsenrath of WSJ summarises the growing Fed split on policy moves. He points how Bernanke summed up the debate in August 2010 monetary policy. The policymakers were divided over whether Fed should reallocate its balance-sheet and buy treasuries as other assets on Fed balance-sheet mature. In the end the dissent was just one (Hoenig) but there was much wider disagreement

After listening intently, Mr. Bernanke summed up the debate, acknowledged the disagreements, and then said that the Fed shouldn’t allow the passive tightening of financial conditions that was being caused by its shrinking balance sheet. In practice, that would mean taking proceeds from nearly $400 billion in maturing mortgage bonds and buying Treasury debt. The Fed also needed to acknowledge the slower growth outlook, he said. The meeting ended later than usual.

The formal vote—9 to 1—disguised the disagreements. Both Mr. Warsh and Ms. Duke voted with the chairman. So did vice chairman Donald Kohn, governor Daniel Tarullo and four of the five regional Fed bank presidents who have votes this year: Mr. Dudley, Mr. Rosengren, St. Louis’ James Bullard and Cleveland’s Sandra Pianalto. Mr. Hoenig, as he has at every opportunity this year, formally dissented.

Yields on long-term Treasury bonds fell after the announcement, as proponents of the move anticipated. But stocks later skidded, evidence to internal skeptics that the Fed misfired.

“We sent some garbled message about a weaker economy where we wanted to be more accommodative,” says Mr. Plosser. “That was confusing and ran the risk of scaring the markets.”

He adds last thing Bernanke would want is deflation in US. Bernanke has studied Great Depression and Japan deflation extensively and lectured on both. The second depression was prevented somehow and with deflation looming, Bernanke is really living through his research:

One thing is clear: Mr. Bernanke, though striving for consensus, is determined to avoid mistakes of past central bankers that created devastating bouts of deflation. As a Princeton professor in the 1990s, Mr. Bernanke lectured Japanese officials for being too timid about combating deflation. And in now-famous remarks he delivered as a Fed governor at a 90th birthday celebration for Milton Friedman in 2002, Mr. Bernanke promised the Fed would never allow a repeat of the deflation of the 1930s.

“The worst outcome for him personally would be to let something like deflation get under way on his watch,” says Alfred Broaddus, the former president of the Richmond Fed who served alongside Mr. Bernanke from 2002 until 2005. “He will respond forcefully to evidence that the risk of a deflationary process getting under way is rising materially. He won’t be ambivalent.”

What a time for Bernanke.

Just to add more to this post. There are a lot of arguments made over unemployment in US. Kocherlakota says much of US unemployment is because of mismatch:

What does this change in the relationship between job openings and unemployment connote? In a word, mismatch. Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs. There are many possible sources of mismatch—geography, skills, demography—and they are probably all at work. Whatever the source, though, it is hard to see how the Fed can do much to cure this problem. Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.

Of course, the key question is: How much of the current unemployment rate is really due to mismatch, as opposed to conditions that the Fed can readily ameliorate? The answer seems to be a lot. I mentioned that the relationship between unemployment and job openings was stable from December 2000 through June 2008. Were that stable relationship still in place today, and given the current job opening rate of 2.2 percent, we would have an unemployment rate of closer to 6.5 percent, not 9.5 percent. Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy.

Krugman jumps on to the speech and says unemployment situation in manufacturing has been worse than construction! So the recession has led to mass problems and it isn’t just about one sector. To be honest, reading Kocherlakota’s speech one would think yes this should be obvious that higher unemployment should be in construction as crisis started from there and still remains in trouble. But Krugman says it is an overall problem.

Meanwhile, WSJ Blog has an interview of Thomas J. Duesterberg, president and CEO of the Manufacturers Alliance/MAPI, a public policy group in Arlington, Va. The message you get is US manufacturing sector is doing quiet well but there are problems ahead as markets are not opening up for exports. So, whatever little growth has happened so far, it has been jobless.

Raghu Rajan in this interview talks about his news book – Fault Lines and says:

I highlight concerns at three levels. My first concern is about the United States, where because of a thin and inadequate safety net, the government responds to global downturns with excessive stimulus so as to avoid job losses. This is not the first jobless recovery we have had, it is the third in a row. Yet we respond with the same failed policies. This sets the stage for subsequent financial excess. Politicians have made thing worse by trying to use easy credit to households as a palliative to paper over other deeper problems the middle class and the poor face, including lack of access to education and stagnant incomes.

(Emphasis is mine). Remarkable how famed US model is coming under so much strain.

So, it is all too complex at the moment. Both economics and economic outlook is all over the place.

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