Missing Federal Reserve Board Members, Hawks and Weak Leadership

The Atlantic has a story with the title “The Most Important Economic Story Nobody Is Talking About”, on how Obama´s failure to fill all the Board of Governors of the Federal Reserve seats has been damaging:

Here’s a depressing reminder: We’re in a $1 trillion hole. That’s how much income we have been losing every year since the onset of the Great Recession. Ben Bernanke and Co. have done a good job preventing a full-on replay of the Great Depression, but Ben Bernanke and Co. have not done a good job preventing a lost decade. The key phrase here is “and Co.”

Bernanke doesn’t set monetary policy by himself. That’s what the Federal Open Market Committee (FOMC) votes on. Its structure is a bit Byzantine and not terribly important, but what is important is that the Fed Chairman usually gets his way without any dissent. That hasn’t been true lately. The Fed’s unconventional measures have unsurprisingly not been too popular with the FOMC’s more conventional members. Unfortunately, that hasn’t stopped Bernanke from trying to reach a consensus. He thinks he needs to. Bernanke recently told Roger Lowenstein that he thinks any policy that doesn’t get at least a 7-3 majority simply won’t be credible. This political calculation gives the hawks more policy influence than they would otherwise have.

And now it looks like there are more hawks. As Greg Ip of The Economist has pointed out, most of Bernanke’s colleagues now want to raise rates before he does. He increasingly looks isolated. Even if Bernanke is inclined to ease a bit more — and reading between the lines, he might be — there’s little chance of it happening. It’s worth remembering that even the hawks’ project  inflation to remain below target and unemployment to remain above target for the next few years. If the Fed believes its own forecasts, it should be doing more.

Regrettably, the Obama administration has consistently underestimated the importance of the Fed. That there are still two empty FOMC seats proves as much. So do the administration’s (blocked) nominees. Consider Peter Diamond. He’s a phenomenal economist — a Nobel-prize winner — who’s clearly qualified to serve on the FOMC. But he’s said that he doesn’t think there’s much more the Fed can do now. Even if he’s right — and I clearly don’t think he is — wouldn’t you rather appoint someone who thinks otherwise and find out if the Fed really is powerless? Someone like … former Council of Economic Advisers Chair Christina Romer.

“Let’s try pushing some more before we declare that we’re pushing on a string”.

I wholeheartedly agree that Obama´s failure to make good board appointments has made life harder for Bernanke. But there´s another reason for what many view as Fed ‘passivity’ and that is Bernanke´s weak leadership qualities.

After all, during Greenspan´s years at the Fed´s helm, the FOMC had its usual assortment of “hawks”. Back in 1991, Murray Rothbard, a quintessential hawk, put it thus:

It is interesting that, of the rulers of the Fed, the only ones that seem to be worried about the inflationary nature of the system are those Fed regional bank presidents who hail from outside the major areas of bank cartels. The regional presidents are elected by the local bankers themselves, the nominal owners of the Fed. Thus, the Fed presidents from top cartel areas such as New York or Chicago, or the older financial elites from Philadelphia and Boston, tend to be pro-inflation ‘doves,’ whereas the relatively anti-inflation ‘hawks’ within the Fed come from the periphery outside the major cartel centers: e.g., those from Minneapolis, Richmond, Cleveland, Dallas, or St. Louis. Surely, this constellation of forces is no coincidence.

During his long tenure, Greenspan had to deal with such Regional Fed hawks as Michael Moskow, Robert Parry, William Poole, Alfred Broaddus (known as ‘chief hawk’), Jerry Jordan, Gary Stern and Thomas Hoenig, with the last two also in Bernanke´s FOMC.

Why, for example, during Greenspan´s years Thomas Hoenig, with all his ‘hawkishness’ never had ‘top billing’ in the media and never had the gall to dissent in eight consecutive meetings?

Or take the case of ‘hawk’ Laurence Meyer who joined the Board in 2006. In one of his first speeches as Fed Governor, Larry Meyer innovated by richly detailing the framework (model) that he uses to make the predictions that ultimately will guide his monetary policy vote:

 [L]let me be specific about the causal structure of the model that underpins my judgment with respect to appropriate monetary policy action.

I am a strong and unapologetic proponent of the Phillips Curve and the NAIRU concept. Fundamentally, the NAIRU framework involves two principles. First, the proximate source of an increase in inflation is excess demand in labor and/or product markets. In the labor market, this excess demand gap is often expressed in this model as the difference between the prevailing unemployment rate and NAIRU, the non-accelerating inflation rate of unemployment. Second, once an excess demand gap opens up, inflation increases indefinitely and progressively until the excess demand gap is closed, and then stabilizes at the higher level until cumulative excess supply gaps reverse the process.

There is a third principle that I subscribe to, which, though not as fundamental as the first two, also plays a role in my forecast and in my judgment about the appropriate posture of monetary policy today. Utilization rates in the labor market play a special role in the inflation process. That is, inflation is often initially transmitted from labor market excess demand to wage change and then to price change. This third principle may be especially important today because, in my view, there is an important disparity between the balance between supply and demand in the labor and product markets, with at least a hint of excess demand in labor markets, but very little to suggest such imbalance in product markets.

It is important to understand that the Phillips Curve is a model of inflation dynamics, not a model that determines the equilibrium inflation rate. For this reason, the Phillips Curve paradigm is not at all inconsistent with the view that inflation is, in the long run, exclusively a monetary phenomenon. Perhaps the easiest way to appreciate this is to recall that the long-run Phillips Curve is widely understood to be vertical. In other words, NAIRU is consistent with any constant rate of inflation, including zero. The Phillips Curve therefore cannot determine inflation in the long run because it is consistent with any constant rate of inflation. What does determine the rate of inflation in the long run? The rate of money growth, of course, though one needs to assume a stable money demand function to get a stable relationship between money growth and inflation. What does the Phillips Curve explain, if not the long-run level of inflation? The answer is that it explains the dynamics of the inflation process, how the economy evolves from one inflation rate to another, for example, in response to an increase in the rate of money growth. The dynamics of changes in inflation operate through excess demand in labor and/or product markets. Thus the Phillips Curve indicates that, if the unemployment rate is maintained at a level below NAIRU, inflation increases over time, progressively and indefinitely.

But contrary to some present day “hawks”, Larry Meyer was a learner (and he gives a lot of credit for that to Greenspan). Early in his book – A term at the Fed – he recounts:

When I arrived at the Board, I thought I had a pretty good idea of what the number (“full employment”) was. But the surprising economic developments during my term – especially the failure of inflation to rise despite declines in the unemployment rate to a level that, in the past, would have triggered higher inflation – soon made me realize that we didn´t really know what that number was at the present moment or what it might be tomorrow…

Maybe Greenspan, not being an academic, was pragmatic. He didn´t appear to have “obsessions”, saying phrases such as: “with the ‘appropriate monetary policy’ we will keep risks to inflation and growth balanced”. What the heck does ‘appropriate monetary policy’ mean? That was for the ‘Fed Watchers’ to figure out!

But Bernanke is obsessed with inflation – in particular with its negative manifestation deflation. He´s not a natural leader, so he could not bring the hawks to see things his way – as he had long ago figured out for Japan – especially during critical junctures. Take, for example, this comment from July 2008, right at the moment aggregate demand (NGDP) was about to take its biggest plunge since 1938:

Following the collapse of Fannie Mae (FNM) and Freddie Mac (FRE), Ben Bernanke’s Congressional testimony last week had Fed watchers predicting interest rates would remain flat, or possibly fall, by the end of the year.

But surging share prices last week and tough talk from two FOMC board members has delivered an expectations U-turn.

According to interest rate futures, investors had priced in a 42 percent chance of a 2008 rate hike following Bernanke’s testimony. But after falling oil prices and not-as-horrible-as-expected earnings from banks drove stocks higher through Thursday, a hike by year-end had been fully priced in by finicky investors.

Then on Friday, Minneapolis Fed President Gary Stern said that the Fed couldn’t wait for the double-threat posed by jittery housing and financial markets to subside in order to fight higher inflation. In similar remarks, the Philadelphia Fed’s Richard Plosser said this morning that rate hikes should be expected “sooner rather than later.”

Adding to the mix, the Financial Times fronted a story with the headline “Fed appears to focus on inflation ahead of growth”:

In effect the Fed has moved from doing whatever it can to support growth, subject to an inflation constraint, to seeking to start raising rates as soon as it can, subject to a growth constraint.

All of this has helped pushed up the expectations of higher rates even further with a hike by October almost fully priced in at 90 percent.

We know nothing of the sort happened and when October came around rates were forcefully reduced!

But weak leadership gives rise to articles with titles such as this, also from The Atlantic: “A rebellion at the Federal Reserve”? which can be interpreted as a cry for change, or to Tyler Cowen´s nihilistic conclusion on “Why Monetary Policy Matters Less each Day”.

I wonder how, in a few decades time, the monetary history of this period will be told.