Tuesday, August 24, 2010

Disagreement Within Fed Over Future Policy

Insight into the August 10th Federal Reserve meeting suggests a divide over the direction of future Fed policy that was concealed by the final vote to reinvest maturing mortgage bonds in treasuries. While some Fed officials are distressed over high unemployment and want to act, the other camp is skeptical of additional stimulus. See the following post from Economist's View.

This gives us a better idea of who to blame for standing in the way of more aggressive policy from the Fed:
Fed Split on Move to Bolster Sluggish Economy, by Jon Hilsenrath, WSJ: The Aug. 10 meeting of top Federal Reserve officials was among the most contentious in Ben Bernanke's four-and-a-half year tenure as central bank chairman.

With the economic outlook unexpectedly darkening, the issue was a seemingly technical one: whether to alter the way the Fed manages its huge portfolio of securities.

But it had big implications: Doing so would plunge the Fed back into the markets and might be a prelude to a future easing of monetary policy, moves that divided the men and women atop the central bank. ... At the end of an extended debate, Mr. Bernanke settled the issue by pushing successfully to proceed with the move. ...

Before the meeting, officials at the Federal Reserve Bank of New York, which manages the Fed's portfolio, had grown concerned ... the ... Fed's portfolio of mortgage-backed securities was about to begin shrinking much more rapidly than anticipated, as low mortgage rates led more Americans to refinance their mortgages. ... A shrinking portfolio in the face of slowing economic growth was unwelcome to many officials, including New York Fed President William Dudley. It amounted to prematurely applying the brakes. ...

The declining mortgage portfolio was the focal point of debate. ... Officials spent very little time discussing the idea of expanding the securities portfolio beyond its current size. ...

Officials were clustered in two camps. In one camp, Mr. Dudley, and the presidents of the Boston and San Francisco Fed banks, Eric Rosengren and Janet Yellen, were distressed that the Fed was far from its objectives of low unemployment and stable inflation. ... This camp was more inclined to act.

The other camp was skeptical. Fed governor Kevin Warsh, a former Wall Street investment banker..., Richard Fisher, president of the Dallas Fed,... Narayana Kocherlakota, president of the Minneapolis Fed,... president of the Philadelphia Fed, Charles Plosser,.., Thomas Hoenig of Kansas City, and Jeffrey Lacker of Richmond...

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 formal vote—9 to 1—disguised the disagreements. ... [Only] Mr. Hoenig, as he has at every opportunity this year, formally dissented. ...

Now the internal debate turns to the future, particularly whether to do more, and if so whether to make small or large steps. ...
My view is that it will take even more bad news about the economy before the Fed will consider additional moves, and if it does move, it will move gradually.

The Fed has been behind the curve since before the crisis started. It didn't see the crisis coming, when the crisis did come it was going to be contained rather than spread and cause bigger problems, and when the problems spread they were going to be short-lived -- Bernanke saw green shoots long, long ago. Now we have Fed officials hesitating once again based upon their relatively rosy expectations for the recovery.

One of the lessons the Fed thinks it learned about inflation is that when you see it, you need to move aggressively. Interest rates should rise by more than one to one with the rise in inflation expectations (this is called the Taylor principle). If you chase inflation upward with gradual steps instead of getting out in front of it and capping it off, you won't catch it until it reaches a very high level, and you may not catch it at all in extreme cases.

But when it comes to the other half of the Fed's mandate, unemployment, there is no sense of urgency, gradualism is fine. But just like inflation, a strategy of delaying and only gradually responding to signals that a problem exists is asking for trouble. Policymakers learned this lesson when inflation was the big problem in the economy, but they haven't figured out that the same lesson applies to situations like we're in (because it's not a feature of models with Calvo price stickiness, the standard model used to evaluate such questions, but that model doesn't do a very good job of capturing the essential elements of our present situation).

Hesitation and gradualism has already allowed unemployment to move far ahead of policy. We need an aggressive move from the Fed to try to catch up, trying to close the gap with small steps in not going to work. But even if the outlook deteriorates further, I doubt that's what we'll get.

This post has been republished from Mark Thoma's blog, Economist's View.
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