Two Kinds of Monetary Policymaking Errors
I gave a paper at the Brookings Papers on Economic Activity (BPEA) conference on Thursday in which, among other things, I argued that the Federal Open Market Committee (FOMC) followed an overly tight policy in 2009-10. More than a few people interpreted the paper as an attempt to explain the change in my own policy stance during my time as President of the Minneapolis Fed. In this post, I explain why that’s not true.
The BPEA paper uses public releases from the past two years to document the intentions of the FOMC in the fourth quarter of 2009 and 2010 for the evolution of the unemployment rate over the medium term (the next two-three years). The median FOMC participant believed that, under appropriate monetary policy, the un- employment rate would fall to about 8% in 2 years and to about 7% in 3 years. The Committee was aiming for a relatively slow recovery in employment, in the sense that the unemployment rate in three years’ time remained well above its long run level.
Of course, the FOMC has two mandates: to promote price stability and to promote maximum employment. It is possible that the FOMC believed that being more aggressive in its pursuit of the latter objective would lead inflation being too high. But the paper uses the same public releases too document that the FOMC was not being restrained by this consideration. In November 2009 and November 2010, the median participant believed that, under appropriate monetary policy, inflation would return to only 1.5% in three years’ time - well below the 2% long-run goal to which most subscribed. At each meeting, only one participant saw it as appropriate for inflation to rise above 2% to facilitate a more rapid return of unemployment to its long-run level.
So, I argue that in the early days of the recovery, the FOMC believed that monetary policy should be used to foster a slow recovery in both unemployment and inflation. My own perspective at the time was different. Basically, I felt that the elevated unemployment rate could be largely attributed to a need for labor market re-allocation in the wake of the housing bust. I believed that needed resource re-allocation would require time to unfold. Given this adjustment process, I felt that trying to facilitate a rapid recovery in the unemployment rate would lead to unduly high inflation. As a result, in November 2009 and November 2010, my economic outlooks were that, under appropriate monetary policy, the unemployment rate would fall to 7.5% and the PCE inflation rate would rise to be 2% or slightly above over the following three years.
Over the next couple years, lots of data eventually proved me wrong about my inflationary concerns. On the macro side, inflation began to soften in 2011. It fell below the FOMC’s new 2% target in early 2012 and has remained there ever since. On the micro side, as nicely summarized by Professor Ed Lazear in his 2012 Jackson Hole presentation, there was a lot of research that suggested that my concerns about unemployment being due to elevated labor market mismatch were largely misplaced.
As a result, in September 2012, I gave a speech favoring keeping interest rates extraordinarily low at least until the unemployment rate reached 5.5%, as long inflation stayed within a quarter percent of the 2% target. The big change, economically, in this speech is that I now thought that the unemployment rate could fall as low as 5.5% without inflation being above 2 1/4%. (It also had implications for my forecast for the evolution of the fed funds rate. But I viewed that forecast as largely uninteresting, as it was sure to change with any new data.)
To summarize: I would say that my policy stance was flawed in 2009-10 because I had an incorrect assessment of inflationary pressures. The FOMC’s stance was flawed (I argue in my paper) because it wasn’t willing to provide sufficient accommodation, given its forecast.
Does this distinction matter? I believe it does. Inflation forecast errors - up or down - by individual Committee members are not likely to be a big deal in the making of monetary policy. A major point of having a Committee is that its collective forecast should be able to drown out those individual errors about the future evolution of the economy. My own assessment is that my own individual forecast error was indeed overridden by the superior collective judgment of the Committee in 2009-10.
In contrast, it seems (to me at least) that the responsibilities of the FOMC to the public are defined by its macroeconomic objectives. It follows that members should agree on those macroeconomic objectives, and to agree too that the FOMC should use monetary policy to pursue those shared objectives with appropriate alacrity. I argue in my BPEA paper that we don't see that kind of alacrity in the Committee’s decisions in 2009-10. And, as I describe here, I don’t see it in Chair Yellen’s recent Jackson Hole speech about the FOMC’s plans to respond to a future recession.
N. Kocherlakota
Rochester, NY
September 17, 2016