Minneapolis Federal Reserve Bank President Narayana Kocherlakota — a new voting member of the Federal Reserve’s policy-setting Open Market Committee — is making headlines in the financial press for his dissenting vote on the Fed’s recent policy statement on interest rates.
But a read of his recent essay on monetary policy casts light on the reasons for his dissent and makes it less surprising.
First, a little background.
Kocherlakota — along with Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser — formally dissented from their seven collegues on the Federal Open Market Committee (FOMC) in pledging to hold interest rates near zero through mid-2013.
That policy statement, issued Tuesday following an FOMC meeting, was viewed as the Fed’s attempt to soothe panicky traders and investors on Wall Street — and temporarily it seemed to work. It was an unusual move in laying out a specific timeframe for keeping interest rates low.
The three dissenting votes, however, sent the financial press atwitter. As reported by Bloomberg News, this represented “the most opposition to a FOMC decision in almost 19 years.”
It’s not that the three Fed presidents wanted to see interest rates pushed up.
Instead of putting a specific time-frame on the low interest rates, they “would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period,” according to the Fed statement on the meeting.
So, they were not urging a change in course, but suggesting that the Fed say little about longer-term interest rates.
Both Kocherlakota and Fisher, responding to press queries, praised Chairman Ben Bernanke’s leadership after casting their dissenting votes.
“On this occasion, I dissented from the committee’s decision,” Kocherlakota said in a prepared statement. “Regardless, I have nothing but the highest regard for the acumen, integrity and ability of all other FOMC meeting participants, including the chairman.”
Annual report describes policy-makers’ dilemma
In an essay accompanying the Minneapolis Fed’s 2010 Annual Report, Kocherlakota laid out the options and limitations facing monetary policy-makers.
The Fed has a twin mandate to “pursue the highest level of employment consistent with price stability” (i.e., hold inflation to acceptable levels). That translates into an inflation rate averaging 2 percent over the next three to four years, according to Kocherlakota. So if he’s willing to lay out a long-term inflation goal, why is the Minneapolis Fed president reluctant to specify the federal funds rate will be held near zero for a specific time period?
In a phrase, things change.
The essential argument he makes is that the Fed’s monetary policy actions lowering interest rates can have very different outcomes in different circumstances. Kocherlakota contrasts the period of the 1970s with the current sour economy.
Kocherlakota’s essay describes how policy-makers “can use real-time data to make monetary policy choices.” He further argues that the unemployment rate and job openings are “highly imperfect guides to the making of monetary policy,” primarily because the economy’s job-creation ability is not fixed but changes over time.
In the 1970s, a Mideast war, followed by the Iranian revolution, sent energy prices shooting through the roof and the economy into twin recessions in 1970-71 and 1974-75. The Fed eased rates, trying to generate economic growth as business had to adjust to the sudden oil shocks.
But the Fed was rowing against the tide — monetary easing was not going to get businesses to hire more employees in the face of such sudden changes in prices and in demand from their own customers. The result was “stagflation” — high unemployment and high inflation – earning the Fed an “F” on its twin mandates of maximum employment and price stability.
The current sour economy has been driven by a different set of factors than in the 1970s. Now, the slow rate of unemployment decline is driven instead by what Kocherlakota describes as nominal rigidities — the sluggish adjustment of prices (including wages) and expectations of future inflation.
In the current circumstances, the Fed’s “highly accommodative policy of low interest rates and large-scale asset purchases was indeed appropriate at the end of 2010,” Kocherlakota argues.
Instead of focusing on unemployment numbers and job openings to influence policy decisions, Kocherlakota intends to keep his eye on inflation, as well as formal and informal comments from business leaders around the region about their expectations for growth — and thus their willingness to create jobs.
So his dissent with Bernanke is not based on a different prescription, but rather on the notion that things can change rapidly. As a result, he is unwilling to publicly commit the Fed to a specific interest rate range for a specific time period.