Hawks can lead to crying

Yesterday, the Fed announced its decision with regard to monetary policy taken at the last Federal Open Market Committee meeting: the federal funds rate remains unchanged at a target range of 0-0.25 %.

However, the accompanying statement added further evidence that the Fed has decided that doing its job is too much to ask. It notes with regard to the current economic situation:

…the economic recovery is continuing at a moderate pace, though somewhat more slowly than the Committee had expected.  Also, recent labor market indicators have been weaker than anticipated.

Ay, there’s the rub! Let’s assume that previously the Fed was providing exactly the amount of stimulus that they thought was needed to fulfill their legal mandate of ensuring stable prices and maximum employment. Then, information that the economy is actually weaker than they previously thought should mean that their stimulus needs to be stronger than they previously thought. Somewhat  strange then, isn’t it, that the Fed seems to think that doing nothing is the appropriate course of action?

By now, this kind of inertia is actually what most people should expect from the Fed. At some point during the financial crisis the FOMC simply stopped doing what they are meant to do, which is to counteract  macroeconomic fluctuations by adjusting monetary policy. The excuse was that they had hit the zero lower bound of nominal interest rates and could do nothing else to stimulate the economy. Then, suddenly, in mid 2009 they decided that they were just kidding, they still had some ammo left, and rediscovered that they could simply buy long-term bonds instead of short-term bonds, a policy named QE1. Since then, everyone has quickly forgotten about the previous pretense that there is nothing you can do at zero nominal interest and we have moved on to pretending that 9% unemployment must be sort of like the “maximum employment” that the mandate is talking about. Mission accomplished! No reason to change policy ever again!

Of course, not changing the interest rate does not mean that monetary policy is not changing (a fact that almost no journalist seems to understand). To illustrate imagine the following: In the summer you are providing “heat stimulus” to your living room by adding logs to the fire at a certain rate, which ensures a pleasant temperature. Now, if suddenly winter comes and the outside temperatures drop precipitously, but you keep adding logs to the fire at the same measured pace as during the summer, what’s going to happen? Your room temperature will get unpleasantly low, as your “heat stimulus” is not appropriate anymore for the changed outside conditions. It is the same with monetary policy: If the economic conditions change, while your policy rate remains the same, the effective “temperature” of monetary policy will change, even though (and because) the policy rate did not move.

So the Fed is messing up, its policy is not responding to changes in the economic environment, but why? Short of attributing extraordinary cruelty to the FOMC members, it seems more reasonable to suppose that their institutional decisionmaking process is somehow faulty. In an earlier discussion of the possibility for a QE3 announcement, Fed watcher Tim Duy observed about the FOMC:

This group looks for nothing more than to avoid commitment, trying to unwind policy as soon as possible.

So the Federal Reserve, torn between the “hawkishly inclined FOMC members”, as Duy calls them, and the more dovish ones, is cautious with regard to bold policy moves and underreacts to new economic developments.

The best explanation I can think of is that the factionalization of the FOMC leads to both hawks and doves being reluctant to agree to let policy move too far in the others’ direction for fear that the consensus-based FOMC voting system would then let the others’ faction block any attempts to let policy return to normal once the economy stabilizes. A full game-theoretic model for this kind of mechanism can be found in this paper of mine.

It is just too bad that along the way this infighting among a small group of policymakers causes widespread suffering among the unemployed and lower living standards for everyone else. Institutions matter, I suppose.

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