August & September 2008 FOMC meetings: The “latch was lifted and the horses bolted!”

In the August 5 FOMC meeting, Mishkin´s last, the inflation worry was alive and well, maybe more so than ever!

There were two options on the table regarding policy. In the first (Alternative B), the Committee would maintain its current policy stance but would underscore its concern about inflation. In the second (Alternative C) the Committee would firm policy by 25 bp.

Janet Yellen was the only participant that wanted to downplay risks to inflation. Most thought that monetary policy was accommodative.

Charles Evans (of Evans-rule fame) would feel comfortable with Alternative C and thought an increase of 50 to 75 basis points in a reasonably short period of time would be needed!

Richard Fisher and Thomas Hoenig favored C (but only Fisher dissented).

James Bullard wanted to “prepare markets for a rate increase in September”. Charles Plosser shared his feelings.

Mishkin and Rosengren leaned towards Yellen´s language.

The charts show the information – on inflation, inflation expectations and oil prices– available to the FOMC at the time of the meeting.

Oil prices had peaked a few weeks earlier and then dropped significantly. Inflation expectations both at the shorter and longer horizon had also fallen.

In particular, the close correlation between shorter (5yrs) inflation expectations and oil prices had “broken” two weeks earlier, pointing to other influencing factors in addition to the fall in oil prices. Maybe that´s associated with the perception that the Fed was on the brink of tightening (remember that the June Meeting Minutes said that “the next interest rate move will likely be up”).

Two speeches by voting Regional Fed presidents certainly helped perceptions along:

Plosner (July 22): Keeping policy too accommodative for too long worsens our inflation problem. Inflation is already too high and inconsistent with our goal of — and responsibility to ensure — price stability. We will need to reverse course — the exact timing depends on how the economy evolves, but I anticipate the reversal will need to be started sooner rather than later. And I believe it will likely need to begin before either the labor market or the financial markets have completely turned around.

Hoenig (July 16): “While the comparison to the ´70s can be useful(!), the present economic situation is also different…

However, like the 1970s, monetary policy is currently accommodative(!)…In this environment there is a significant risk that inflation and inflation expectations could move higher in coming months.

Thus, it will be important for the Federal Reserve to monitor inflation developments and inflation expectations closely, and to move to a less accommodative stance in a timely fashion”.

I think the high point of the August 5 meeting was Mishkin´s “farewell speech”:

What I’d like to spend some time on—because I feel this is sort of my swan song, but maybe because I’m a classy guy, I’ll call this my “valedictory remarks”—are three concerns that I have for this Committee going forward. I’m not going to be able to participate, but I have a chance now to lay them out.

The first is the real danger of focusing too much on the federal funds rate as reflecting the stance of monetary policy. This is very dangerous. I want to talk about that.

Second is that I think it’s absolutely critical that we keep our options open in the current circumstances, and so I want to talk about that.

The third is on the communication issue, but it’s not going to be on inflation objectives. I’ve already talked about that enough in public, so it’s clear to you one way or the other. I hope you consider it, but that’s something that I don’t need to go into here.

I´ll transcribe from the first and third concern, as he wasn´t particularly helpful on the second:

First of all, let me talk about the issue of focusing too much on the federal funds rate as indicating the stance of monetary policy. This is something that’s very dear to my heart. I have a chapter in my textbook that deals with this whole issue and talks about the very deep mistakes that have been made in monetary policy because of exactly that focus on the short-term interest rate as indicating the stance of monetary policy. In particular, when you think about the stance of monetary policy, you should look at all asset prices, which means look at all interest rates.

All asset prices have a very important effect on aggregate demand. Also you should look at credit market conditions because some things are actually not reflected in market prices but are still very important. If you don’t do that, you can make horrendous mistakes. The Great Depression is a classic example of when they made two mistakes in looking at the policy interest rate. One is that they didn’t understand the difference between real and nominal interest rates. That mistake I’m not worried about here. People fully understand that. But it is an example when nominal rates went down, but only on default-free Treasury securities; in fact, they skyrocketed on other ones.

The stance of monetary policy was incredibly tight during the Great Depression, and we had a disaster.

The Japanese made the same mistake, and I just very much hope that this Committee does not make this mistake because I have to tell you that the situation is scary to me. I’m holding two houses right now. I’m very nervous. [Laughter].

The third issue is something about which I am less constrained, which is communications. I would not have talked about this earlier, but it really does worry me. We have a complicated governance structure in this Committee, which I actually think is the right governance structure.

We have two types of groups that vote on this Committee. We have the people who are Presidential appointees and then confirmed by the Senate, who are Board members, and I will soon not be one of them. I’ll be a civilian again. Then we have Bank presidents, who are much more tied into the private sector because your boards of directors, which are composed of private-sector people, recommend you. Then we do have some role, but they’re the primary people who decide who becomes a Bank president.

I think that’s a very good framework. It actually serves us very well. I’ve been on both sides. I’ve been on the other side of the fence, not as a president but as an executive vice president.

It serves us very well because we have a link to the private sector that we normally would not have; importantly, it keeps us real in terms of information; and there’s a group of people out there who are not in Washington or New York (because people also have a hard time about New York) but who tend to be very important supporters for us politically. So this is a system that I would very much like to see preserved. It does have a problem because of the different roles here.

What I have been very concerned about—and I have had people in the markets speak to me about this—is that recently I had a very prominent central bank governor say to me, “What in the hell are you guys doing?” The issue here is that we need to have a situation where Bank presidents and also members of the Board can speak their views. They may have different views, and I very much encourage that in terms of discussion, of where they think the economy is going, which is what we do inside; and I think that does need to be done outside the Committee because it shows that there are different views, that we’re thinking about it, that we’re trying to learn from each other, and so forth and so on.

What is very problematic from my viewpoint are the speeches, discussions, and interviews outside, when people talk about where they think interest rates should head and where the policy rate should head. That’s where the criticism has been coming from. I have to tell you that a lot of people whom I respect tremendously are saying to me that it’s making us look like the gang that can’t shoot straight. I think it’s a really serious problem. I understand that we want to keep the priority of speaking our minds, but we have to work as a team, and I think that we’re having a problem in this regard.

Let me talk about why I think this is dangerous. It’s dangerous in terms of policy setting. You can see this is very blunt. Clearly, if you were in a multi-period game, you wouldn’t be this blunt. But now I’m not going to be here anymore, so you can hate me—I don’t care. [Laughter]

But this kind of cacophony on this issue has the potential to damage us in two very serious ways.

One is that it weakens the confidence in our institution, and I have to tell you that I love this institution. It’s very hard for me to leave this place, but it’s something I have to do. If the institution is damaged in terms of the confidence that the public and the politicians have in us, it will hurt us deeply. It will hurt us in terms of policy because it will weaken our credibility, which actually will make it harder to control inflation. So I consider this a very serious cost.

More than 5 years on, it seems members heard but didn´t listen!

And six weeks later the “latch” was completely removed. And the boss was instrumental. Bernanke said on the September 16 FOMC meeting (just 24 hours after Lehman):

As I said, I think our aggressive(!) approach earlier in the year is looking pretty good(!), particularly as inflation pressures have seemed to moderate.

Overall I believe that our current funds rate setting is appropriate, and I don’t really see any reason to change.

On the one hand, I think it would be inappropriate to increase rates at this point. It is simply premature. We don’t have enough information. There is not enough pressure on inflation at this juncture to do that. On the other hand, cutting rates would be a very big step that would send a very strong signal about our views on the economy and about our intentions going forward, and I think we should view that step as a very discrete thing rather than as a 25 basis point kind of thing. We should be very certain about that change before we undertake it because I would be concerned, for example, about the implications for the dollar, commodity prices, and the like. So it is a step we should take only if we are very confident that that is the direction in which we want to go.

And this is the information on inflation expectations and oil prices that the FOMC had at the time of the meeting!

Note that not even oil prices resisted the (now ‘certain’) expected steep fall in aggregate demand! Not surprisingly, it materialized!

For the rest of the year, in regular and unscheduled FOMC meetings, what we perceive from the transcripts is a frantic and disorganized search for the “horses that bolted”.

PS. There´s one passage in the October 08 meeting that is reminiscent of a November 1937 FOMC meeting.

An interesting story of the time is told by Anasthasios Orphanides. In March 1937, just before the final leg of the increase in required reserves was implemented, Marriner Eccles, the Fed Chairman said:

Recovery is now under way, but if it were permitted to become a runaway boom it would be followed by another disastrous crash.

Several months later, halfway through the recession, at the November 1937 meeting John Williams, a Harvard professor, member of the Fed board and its chief-economist said:

We all know how it developed. There was a feeling last spring that things were going pretty fast … we had about six months of incipient boom conditions with rapid rise of prices, price and wage spirals and forward buying and you will recall that last spring there were dangers of a run-away situation which would bring the recovery prematurely to a close. We all felt, as a result of that, that some recession was desirable … We have had continued ease of money all through the depression. We have never had a recovery like that. It follows from that that we can’t count upon a policy of monetary ease as a major corrective. … In response to an inquiry by Mr. Davis as to how the increase in reserve requirements has been in the picture, Mr. Williams stated that it was not the cause but rather the occasion for the change. … It is a coincidence in time. … If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground.

And Tim Geithner in 2008:

The argument that makes me most uncomfortable here around the table today is the suggestion several of you have made—I’m not sure you meant it this way—which is that the actions by this Committee contributed to the erosion of confidence—a deeply unfair suggestion.

… But please be very careful, certainly outside this room, about adding to the perception that the actions by this body were a substantial contributor to the erosion in confidence.