Over the past few years, there’s been a huge split between monetary hawks and doves. Hawks are afraid the Federal Reserve is doing too much and risking inflation, and doves worry that the Fed isn’t doing enough to stimulate the economy during a period of weakness.
In some ways, the dichotomy is a false one. Explaining why that is could fill up a book, but Minneapolis Fed president Narayana Kocherlakota managed to do it in a very short and (by usual Fed standards) very understandable speech in Duluth yesterday.
Before delving into his speech, some background on Kocherlakota. Until very recently, Kocherlakota was one of the biggest inflation hawks in the Federal Reserve system. A prodigy who’d enrolled at Princeton at age 15, Kocherlakota came to the Fed from the University of Minnesota, a school known for its "freshwater" economics department*. He served on Federal Open Markets Committee (the group that makes the Fed’s monetary policy decisions) last year, and quickly gained notice for his dissents from the committee’s decisions to loosen monetary conditions.
In August of last year, Kocherlakota voted against Bernanke and co.’s decision to promise low interest rates for a longer period of time, citing rising inflation and falling unemployment as a reason not to do any more stimulus. As recently as June of this year, Kocherlakota was calling for a hike in interest rates as early as this fall to stave off future inflation.
In the meantime, Bernanke himself took the time to personally convince Kocherlakota to change his outlook, emailing back and forth with the Minneapolis Fed president about monetary theory. Whatever Bernanke said, it was persuasive, as Kocherlakota is no longer on the hawks’ side at all. And that’s where yesterday’s speech comes in.
Kocherlakota speech indicates that he hasn’t changed his mind about the role of the Fed in maintaining price stability. Instead, he rejects the idea that the Fed should be doing “more” or “less,” and argues that the Fed’s role should be determined by the state of the economy:
The public discourse about the Fed often focuses on our financial transactions in isolation, and the links back to our Main Street objectives are not always apparent. This disconnect is always problematic, but…it is especially so today.
Kocherlakota notes that, viewed without the proper context, the Fed has done a whole lot over the past few years – QE1, QE2, and QE3, “Operation Twist,” etc. But there is a larger context in which those actions should be regarded:
...observers argue that the Fed has done too much, has been too accommodative. I strongly disagree. These critics are certainly right that the Fed’s actions—tripling its balance sheet and keeping the fed funds rate near zero for years—are historically unprecedented. But it is also clear that the economy has been hit by the worst shock in 80 years.
The fact of this shock means it’s misleading to compare what the Fed’s doing now, in terms of bond purchases and other maneuvers, to what it’s done over the past 30 years, when conditions have been different. The proof that the current situation calls for unusual measures, Kocherlakota argues, is that both current and forecasted inflation are running below the Fed’s 2 percent target. “Given how high unemployment is expected to remain over the next few years,” Kocherlakota concludes, “these inflation forecasts suggest that monetary policy is, if anything, too tight, not too easy.”
In other words: yes, the Fed has done a done of bond-buying and other stimulus by historical measures. But, looking at how short inflation and employment are of the Fed’s targets “does not suggest that monetary policy is currently too easy,” in Kocherlakota’s words.
Although Kocherlakota doesn’t spell it out, this comparison goes both ways. The Fed can’t fulfill its stated goals without measures that would be considered highly stimulative by normal standards. At the same time, monetary stimulus is ineffective if the Fed hasn’t clearly spelled out what its goals are.
The Fed didn’t specify any targets to two of its largest programs of the past few years, QE2 and “Operation Twist.” By Kocherlakota’s logic, the lack of clarity about what those bond purchases were intended to accomplish likely lessened their effectiveness by depressing investors’ confidence and increasing uncertainty. By tying QE3 to set (if vague) goals, the Fed probably will do less with more.
* It's worth noting, for the purposes of this post, that Kocherlakota himself has cast doubt on the idea that there's a saltwater-freshwater divide in modern macroeconomics (pdf).