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March 22, 2014

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Fed Watch: Kocherlakota's Dissent

Posted: 22 Mar 2014 12:33 AM PDT

Tim Duy:

Kocherlakota's Dissent, by Tim Duy: Minneapolis Federal Reserve President Narayana Kocherlakota defended his dissent at the March FOMC meeting. I thought it was quite remarkable. The reason of the dissent itself is not particularly unexpected:

I dissented from the new guidance for two reasons. The first reason is that the new guidance weakens the credibility of the Committee's commitment to target 2 percent inflation. The second reason is that the new guidance fosters policy uncertainty and thereby suppresses economic activity.

I have already discussed the implications of dropping the Evans rule in regards to inflation. It implies an intention to approach the inflation target from below as well as a lack of tolerance for above target inflation. As far as the second point, Kocherlakota is arguing that the lack of quantitative guideposts increases uncertainty about the path of policy and that uncertainty tends to make economic agents risk adverse. Market participants, for example, might rationally believe they should react to that risk by moving up their expectations of the first rate hike, which by itself induces somewhat less accommodative policy.

More interesting, in my opinion, was Kocherlakota's alternative language. Consider for a moment the Evans rule as it was in January:

The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

Now consider Kocherlakota's version of the Evans rule:

For example, the Committee could have adopted language of the following form: "the Committee anticipates keeping the fed funds rate in its current range at least until the unemployment rate has fallen below 5.5 percent, as long as the one-to-two-year-ahead outlook for PCE inflation remains below 2 1/4 percent, longer-term inflation expectations remain well-anchored, and possible risks to financial stability remain well-contained."

Kocherlakota has to come up with something he can sell to the rest of the FOMC. It says something about the rest of the FOMC that the most he thinks he can sell is a meager 25bp bump above the Federal Reserve inflation target. It says even more if that's the most he could sell to himself. If the most dovish member of the FOMC can tolerate no more than a 25bp upside miss on inflation, what does it say about the other FOMC members? Regardless of whether this is Kocherlakota's max or the best he thinks he can get, it tells you that 2% is really a ceiling, not a target. Now, generously, it maybe that the FOMC believes that they cannot exceed 2% politically given the amount of extraordinary stimulus already in place. But that still leaves 2% as a ceiling.

Moreover, look at the addition of the "possible risks to financial stability remain well-contained" language. It is no longer just about the length of accomodative policy, but about the first rate hike itself. It suggests that a rate hike to snuff out financial stability is clearly on the table. Moreover, if Kocherlakota thinks the only way he can sell his new version of the Evans rule is address financial stability, it means that such concerns are already an impediment to even more supportive monetary policy. This is something I noted yesterday with respect to Yellen's comments about the tapering debate last spring.

In short, if you believe that the Fed will not use monetary policy to address financial stability concerns, I think you might not be paying attention. They are already using monetary policy to address those concerns by not taking more aggressive action. Don't look to what they will do in the future for confirmation; look to what they are not doing right now.

Bottom Line: Kocherlakota's dissent paints the rest of the FOMC as surprisingly hawkish.

Links for 3-22-14

Posted: 22 Mar 2014 12:06 AM PDT

'Labor Markets Don't Clear: Let's Stop Pretending They Do'

Posted: 21 Mar 2014 11:07 AM PDT

Roger farmer:

Labor Markets Don't Clear: Let's Stop Pretending They Do: Beginning with the work of Robert Lucas and Leonard Rapping in 1969, macroeconomists have modeled the labor market as if the wage always adjusts to equate the demand and supply of labor.

I don't think that's a very good approach. It's time to drop the assumption that the demand equals the supply of labor.
Why would you want to delete the labor market clearing equation from an otherwise standard model? Because setting the demand equal to the supply of labor is a terrible way of understanding business cycles. ...
Why is this a big deal? Because 90% of the macro seminars I attend, at conferences and universities around the world, still assume that the labor market is an auction where anyone can work as many hours as they want at the going wage. Why do we let our students keep doing this?

'The Counter-Factual & the Fed’s QE'

Posted: 21 Mar 2014 09:55 AM PDT

I tried to make this point in a recent column (it was about fiscal rather than monetary policy, but the same point applies), but I think Barry Ritholtz makes the point better and more succinctly:

Understanding Why You Think QE Didn't Work, by Barry Ritholtz: Maybe you have heard a line that goes something like this: The weak recovery is proof that the Federal Reserve's program of asset purchases, otherwise known as quantitative easement, doesn't work.
If you were the one saying those words, you don't understand the counterfactual. ...
This flawed analytical paradigm has many manifestations, and not just in the investing world. They all rely on the same equation: If you do X, and there is no measurable change, X is therefore ineffective.
The problem with this "non-result result" is what would have occurred otherwise. Might "no change" be an improvement from what otherwise would have happened? No change, last time I checked, is better than a free-fall.
If you are testing a new medication to reduce tumors, you want to see what happened to the group that didn't get the test therapy. Maybe this control group experienced rapid tumor growth. Hence, a result where there is no increase in tumor mass in the group receiving the therapy would be considered a very positive outcome.
We run into the same issue with QE. ... Without that control group, we simply don't know. ...

The Fool on the Icy Hill

Posted: 21 Mar 2014 09:21 AM PDT

As a follow-up to Krugman's article, this is something I wrote in January of 2009:

...I think the stimulus package is like driving up an icy hill. If you don't have enough momentum from the start and fail to provide enough "stimulus" to get the car over the crest of the hill, you can slide all the way back to the bottom, crashing into things along the way and ending up worse off than when you started. Maybe you can give it more gas along the way if needed without spinning out, and perhaps you can hold your position if you don't make it to the top, and then start again from the higher level, but that's not a chance I want to take when I'm sitting at the bottom wondering if I can make it to the top without wrecking my car -- the possibility of falling all the way back to the bottom and ending up worse off would make me want to start with sufficient momentum and then some. Essentially, I am arguing that there are crucial economic and psychological "tipping points" that must be reached in order for the economic recovery package to be effective (or at least, there's enough of a chance that they exist that they cannot be ignored when formulating robust policy). ...

Paul Krugman added:

I'd add that there may also be a political tipping point: if the stimulus package is too weak, conservatives will pile on after it fails to deliver, claiming that the whole concept has been discredited.

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