NEW YORK – If the Federal Open Market Committee followed the “rules” of economics, they would have tightened policy at their August 9th meeting instead of easing policy, according to Federal Reserve Bank of Minneapolis President Narayana Kocherlakota.
Comparing the economic situation in August to November, the last time the FOMC made a policy move, “measures of past and forecasts of future inflationary pressures were higher,” while “labor market slack and expectations of future labor market slack were smaller in August,” he told the National Association of State Treasurers in Bismarck, N.D., according to text released by the Fed. “The monetary policy rules” say: “`Don’t ease further if you’re doing better on your mandates.’ Indeed, they’d recommend that the level of policy accommodation be reduced,” Kocherlakota noted. “Instead, at its August meeting, the FOMC decided to adopt a more accommodative policy stance,” changing its statement to define “extended period” as 16 meetings instead of “two or three meetings.”
He noted that using a decline in the unemployment rate as representing a decline in labor market slack is a bit controversial since it can mean people found jobs or stopped looking for work. “Intuitively, people who are non-employed, but not actively looking for work, are less likely to apply for any given job opening. Hence, the recent departures from the labor force imply that there is less downward pressure on wages. Almost by definition, from an economic perspective, this means that there is less slack in the labor market.”
Also, core inflation increases are consistent with declining labor market slack. If, as some contend, the rise core PCE inflation is only temporary, as a result of events in Japan or transitory spikes in commodity price, “the disinflationary pressures of 2010 should soon reappear in the form of a sharp decline in current and expected core PCE inflation rates. In that eventuality, increasing policy accommodation might well be appropriate,” he said.
The problem with overly accommodative policy is that it risks “generating inflation higher than 2% for several years. … such an outcome could have significant consequences for inflation and inflation expectations. Future Committees might have to endure large losses in employment in order to fix these consequences,” Kocherlakota said.
The shocks of the past few years “had the potential to drive inflation significantly downward,” he added. “I believe that the FOMC’s clear communication of its inflation objective has helped the FOMC keep inflation from falling too low in the face of those shocks. At the same time, clear communication of its objective has also allowed the FOMC to follow highly accommodative monetary policies—like keeping interest rates near zero for nearly three years—without triggering large upward movements in inflationary expectations.”
But, he noted, communication only works if the FOMC is credible. It is more difficult to “quantify the maximum employment mandate than the price stability mandate.” He added that “maximum employment” is affected by “changes in minimum wage policy, demography, taxes and regulations, technological productivity, job market efficiency, unemployment insurance benefits, entrepreneurial credit access and social norms” all influence what we might consider “maximum employment.”
“Trying to offset these changes in the economy with monetary policy can lead to a dangerous drift in inflationary expectations and ultimately in inflation itself,” he said.
The Fed has “met its price stability mandate and is expected to continue to do so.” While unemployment is “disturbingly high,” without the stimulus, it would be higher, he said. “Moreover, I believe that the FOMC could only have systematically lowered the unemployment rate further by generating inflation rates higher than 2% over a multiyear period. Such an outcome could well lead the public to lose faith in the credibility of the FOMC’s inflation objective and thereby increase the probability that the FOMC would lose control of inflation.”
He added, “the FOMC consistently made choices in response to changes in short-term economic conditions that were designed to support its medium-term objectives.”
