BFI NewsMar 18, 2016

Monetary Policy: A Matter of Communications and Decision-Making

Monetary policy can be a good tool to help the economy rebound from shocks. By lowering interest rates, the Federal Reserve can boost investment and spending to stimulate growth, which pushes upward on prices and employment.

But monetary policy is tempered by other forces: fiscal policy, labor markets, global economic trends, and notably, people’s expectations. Managing those expectations has become a key part of policymaking, according to Narayana Kocherlakota, who from October 2009 to December 2015 served as president of the Federal Reserve Bank of Minneapolis.

Kocherlakota, PhD’87 (Economics), shared his views on prudent Fed policy March 8 in a conversation with his former PhD thesis advisor, institute director and Nobel laureate Lars Peter Hansen. With inflation remaining well below the Fed’s 2 percent target, even after seven years of interest rates near or at zero, Kocherlakota suggested that a decline in expectations about inflation may begin to undercut the power of future Fed moves.

“What is the Fed’s biggest fear? That longer-term inflation expectations start to drift downward or upward,” noted the former member of the Federal Open Market Committee. Such changes affect the short-term effectiveness of policy moves. He showed data tracking a steady decline from 2013 onward in the inflation rate people think the Fed will deliver five to ten years in the future. “That’s a real challenge for the Fed,” he said.

The Fed has a dual monetary policy mandate of promoting maximum employment while managing the price level at an acceptable inflation rate. Kocherlakota acknowledged that long-term employment is shaped by market conditions, demographics, and other factors beyond the Fed’s control.   As a result, he said “the Fed has been very sharp and clear about its 2 percent inflation target; how to quantify the full employment mandate is more fluid over time.”

With charts, he showed that the Fed’s highly accommodative monetary policy over the past six years was associated with a steady decline in the unemployment rate. However, the data also showed that the fraction of adults in their prime working years who have a job has not recovered to pre-financial crisis levels.

Kocherlakota emphasized that there are limits to what the Fed can accomplish in terms of labor market outcomes.  “Monetary policy is not a free good. You have to be careful, because what you do can cause inflation. You’re not going to do everything in your power to bring the unemployment rate down; that’s going to have costs in terms of inflation,” Kocherlakota said.

Some observers see a tension between the dual goals of promoting maximum employment and maintaining price stability, Kocherlakota said.  In the last decade, however, despite unprecedented monetary policy actions, both employment and inflation “are running too low.”

“I just showed you the data; there’s no tension there,” Kocherlakota told the audience. Given these economic conditions, “I don’t see it would be prudent to increase rates; it might be worth lowering them,” he said.

Asked about the considerations that had led the Fed to choose 2 percent as its inflation target, he said, “I think our experience at the zero lower bound could argue for raising the target. But, he noted, that also means managing expectations: “If you say 2 percent, then if later you say 3, people might think you mean 5.”

Hansen asked his former student about the high level of public attention and criticism the Fed attracts. Kocherlakota said he is not bothered by Fed-watching. “It’s very reasonable to be held accountable for failure to hit that 2 percent [inflation] target,” he added, noting that a little help from Congress in the form of more stimulus and less austerity would have helped.

He did express reservations about some aspects of the scrutiny on the Fed.  He noted that, even in the throes of the crisis, much of the public discussion about the Fed, and communication from the Fed, was about when emergency measures would end and policy would “get back to normal … I wish more of the conversation was about ‘Why isn’t the Fed hitting its target?’ rather than ‘Why is the Fed doing so much?’”

He compared Interest rates to the volume button on a television’s remote control. When the sound level changes between programs and ads, “you would not keep the volume the same; you would not change it slowly.” The discussion should center around whether we have the sound right, not whether the setting on the remote is close to its normal position. “The only thing that matters is hitting your objectives,” he said.

Hansen responded, “You’re saying the Fed should announce a 2 percent inflation target and do whatever it takes to get there, but you just showed us time series data that showed you couldn’t do that.”

“Your point is a good one,” Kocherlakota replied. “If you say you’re going to hit 2 percent and you’re not hitting it, you’re losing credibility. It’s not just about communications, it’s communications and decision-making.”

Kocherlakota joined the University of Rochester on January 1, 2016 as Lionel W. McKenzie Professor of Economics. The distinguished academic left the Fed at the end of last year, and in comparing the two roles, he said he enjoyed drawing on a wider range of models and approaches as a policymaker than academics typically do. He expressed some disappointment that there has not been more academic research addressing the unique real-world economic conditions of the last decade.

In closing, Hansen asked Kocherlakota if he agreed with former chairman Bernanke that FOMC meetings were, in Bernanke’s words, “scripted and boring.” Kocherlakota, who in August 2011  went off-script with a rare and public dissent with an FOMC statement, said the scripting is really necessary preparation. “Most meetings should be boring,” Kocherlakota said.  “The committee meets eight times a year, and we shouldn’t be coming in thinking that the end of the world’s coming, so let’s save the world this meeting.”

—Toni Shears