Just how political is the Fed?
By Scott Sumner
The Fed likes to portray itself as being a bunch of selfless, well-meaning technocrats, who faithfully try to carry out the mandate they have been given by Congress. Is this true, or has the Fed been politicized?
There’s a certain type of intellectual that likes to say, “everything’s political”. I’ve never found that way of thinking to be particularly interesting, as if everything is political then saying “X is political” provides essentially no information about X. So let’s use a more restrictive definition, where monetary policy is political if the Fed chooses to pursue goals other than what Congress asked them to do. Thus, for instance, the Arthur Burns Fed was pretty clearly political. So what about today?
Here’s CBS Moneywatch:
While the Fed minutes were, on the surface, seen as dovish given the focus on the recent decline in inflation pressure and retail sales softness, the details were decidedly less so. Policymakers warned of “elevated vulnerabilities” to financial stability from high asset prices, saying directly that monetary policy would run tighter “than otherwise was warranted” to address this risk.
If true, that would suggest the Fed is going well beyond their mandate, which does not include determining the proper level of asset prices. But is it true? I searched the July minutes, and could find no evidence that the Fed actually said what Moneywatch claims it said. Indeed the only place where the Fed minutes used the phrase “than otherwise was warranted” was here:
Several participants noted that the further increases in equity prices, together with continued low longer-term interest rates, had led to an easing of financial conditions. However, different assessments were expressed about the implications of this development for the outlook for aggregate demand and, consequently, appropriate monetary policy. According to one view, the easing of financial conditions meant that the economic effects of the Committee’s actions in gradually removing policy accommodation had been largely offset by other factors influencing financial markets, and that a tighter monetary policy than otherwise was warranted. According to another view, recent rises in equity prices might be part of a broad-based adjustment of asset prices to changes in longer-term financial conditions, importantly including a lower neutral real interest rate, and, therefore, the recent equity price increases might not provide much additional impetus to aggregate spending on goods and services.
Here the Fed is saying that because of an easing of financial conditions, aggregate demand is stronger than one would normally expect from this stance of monetary policy. There is nothing about popping asset price bubbles with a policy that is too tight to achieve the inflation target.
Some argue that the persistence of sub-2% inflation indicates that the Fed has a hidden agenda—reducing asset prices at the expense of falling short of its inflation objective. Maybe, but perhaps they simply missed their target. After all, the Fed persistently forecasts that inflation will return to 2% relatively soon. This is from the minutes of the July meeting:
The staff continued to project that inflation would increase in the next couple of years and that it would be close to the Committee’s longer-run objective in 2018 and at 2 percent in 2019.
I suppose it’s possible that these figures are in some way fake, and don’t reflect the actual expectation of FOMC members. If so, it’s a pretty widespread conspiracy, with the consensus of private sectors forecasters in on the devious plot to foist 1.5% inflation on America. Here’s the most recent survey of private sector forecasts:
The Fed targets headline PCE inflation, which private sector forecasters project at 1.5% this year, 1.9% in 2018, and 2.0% in 2019. Now reread the Fed minutes—it’s almost eerie how close they are. And private sector forecasters have no incentive to cheat–their reputation depends on their accuracy.
Does that mean all’s well at the Fed? Not necessarily. Perhaps both the Fed and the private sector consensus put too much weight on Phillips Curve models. A growing minority at the Fed seems willing to question this approach to inflation forecasting:
A number of participants noted that much of the analysis of inflation used in policymaking rested on a framework in which, for a given rate of expected inflation, the degree of upward pressures on prices and wages rose as aggregate demand for goods and services and employment of resources increased above long-run sustainable levels. A few participants cited evidence suggesting that this framework was not particularly useful in forecasting inflation. However, most participants thought that the framework remained valid, notwithstanding the recent absence of a pickup in inflation in the face of a tightening
labor market and real GDP growth in excess of their estimates of its potential rate.
I suspect that some of the skepticism comes from the Minneapolis and St. Louis Federal Reserve banks.
I share this skepticism about using the Phillips Curve as a predictor of inflation. I would also note that TIPS spreads are currently forecasting that inflation will remain well below 2% going forward. Call me naive, yet I’m still not convinced that this is evidence of a politicized Fed. Until we get a sustained divergence between Fed inflation forecasts and private sector consensus forecasts, I’ll continue to assume that the Fed consists of well-meaning technocrats doing the best they can with a flawed Phillips Curve model.
But that’s still really bad! We need a market-directed policy, not a policy reliant on the skills of 12 FOMC members.