The Twisted Logic Behind the Federal Reserve Dissenters' Arguments

Sep 22, 2011Mike Konczal

Three members are living in a world very different from what the unemployed are experiencing.

I made the case that liberals should engage monetary policy more directly in The New Republic today. I want people to pay special attention to the Evans Rule, which derives from Chicago Fed President Charles Evans's fantastic speech "The Fed's Dual Mandate: Responsibilities and Challenges Facing U.S. Monetary Policy." The rule proposes that the Federal Reserve could simply state that it will keep interest rates at zero and tolerate three percent average inflation until unemployment gets down to seven percent. I'd consider going further and announcing a targeted transition to a permanent four percent inflation target, while keeping rates near zero until unemployment is at least 6.5 percent. But these are the areas where liberals need to focus their energy when it comes to monetary policy.

Because Operation Twist won't cut it, especially with the housing market a complete mess. But even this mediocre action had three dissenting votes: Fed Presidents Richard Fisher, Narayana Kocherlakota, and Charles Plosser.

Having a map of the demand-and-supply sides of the policy debates is crucial to analyzing their arguments, and I'll allude to it throughout this post. The dissenting arguments aren't in the demand side, but instead in the supply side. Instead of thinking we have a demand problem but that monetary policy is ineffectual in this environment -- an opinion held by many people -- their explanations for why they are against future monetary policy use the language of the supply-side.

We don't know yet exactly why they dissented this time, but there are clues from their previous statements. To understand Fisher's perspective, there is this clue from the August 20th FOMC meeting (my bold for the following three quotes):

Voting against this action: Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser... Mr. Fisher discussed the fragility of the U.S. economy but felt that it was chiefly nonmonetary factors, such as uncertainty about fiscal and regulatory initiatives, that were restraining domestic capital expenditures, job creation, and economic growth. He was concerned both that the Committee did not have enough information to be specific on the time interval over which it expected low rates to be maintained, and that, were it to do so, the Committee risked appearing overly responsive to the recent financial market volatility...

He said something similar in an August 17th speech applauding Texas' job growth. "Those with the capacity to hire American workers -- small businesses as well as large, publicly traded or private -- are immobilized. Not because they lack entrepreneurial zeal or do not wish to grow; not because they can’t access cheap and available credit. Rather, they simply cannot budget or manage for the uncertainty of fiscal and regulatory policy." That logic falls under the "government-induced uncertainty" circle in my map.

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For Kocherlakota, a clue lies in his big paper "Labor Markets and Monetary Policy," which states:

There are good reasons to believe that expected after-tax productivity p fell. Over the past three years, the U.S. economy has experienced large increases in the federal budget deficits, contributing substantially to the overall federal debt. In addition, many states and municipalities are facing budgetary challenges. It is natural for firms to expect that these budget challenges at all levels of government may be met at least partially by future increases in tax rates. Both in the model and in reality, firms know that hiring a worker is a multiyear commitment, and so what matters for that decision is productivity, net of taxes, over the medium term of the next several years. If firms expect to face higher taxes in this time frame, then their measure of p has fallen.

What about the utility that a person derives from not working? In response to the recession, the federal government extended the duration of unemployment insurance benefits. Thus, it is plausible that z has risen in the past three years. This increase -- in and of itself -- means that firms must offer higher wages... In this scenario, nominal rigidities are playing a much less important role in suppressing the creation of job openings. Correspondingly, monetary policy should be considerably less accommodative... However, if (p−z) has fallen by 0.15, then the implied u* is 8.7 percent. This is indeed a wide range of possibilities.

The biggest factors for him are government-induced uncertainty created by budgetary challenges, future tax increases, and unemployment insurance. In Kocherlakota's models, the natural rate of unemployment might be 8.7 percent or higher, so in his mind he's gotten us to Full Employment. Congrats!

Mind you, the models he uses don't even really leave room for insufficient demand to be part of the story, which is kind of a problem. But either way, he falls into the overlap between "government-induced uncertainty" and "productivity."

What about Plosser? Here's a February 2011 interview with the Wall Street Journal:

Mr. Plosser’s answer is unequivocal: This mess was caused by over-investment in housing, and bringing down unemployment will be a gradual process. “You can’t change the carpenter into a nurse easily, and you can’t change the mortgage broker into a computer expert in a manufacturing plant very easily. Eventually that stuff will sort itself out. People will be retrained and they’ll find jobs in other industries. But monetary policy can’t retrain people. Monetary policy can’t fix those problems.”

Scott Sumner has devastated the argument that this is about unemployed carpenters with a passing glance at the data, and as far as I can see Plosser has offered little additional data on this matter. And again, even if the "natural" rate of unemployment has jumped up to 6 percent or 7 percent, there are still millions of people who are unemployed and who can be affected by policy. But either way, he's operating from the "labor productivity" circle in the map.

So the three dissenters don't have a demand story in which monetary policy can't work. They have a story in which things would be fine if the government just got out of the way and stopped trying to regulate the financial sector, focused on balancing the budget immediately, and also stopped preventing people from moving to new careers by giving them unemployment insurance.

How did these people ever end up being some of the most crucial players with control over whether or not our country will leave the Great Recession and get back to full employment?

It would have been great if Charles Evans had dissented on behalf of the unemployed. It is important for the public to understand that the dissenters aren't balancing out a Fed that is too active, but instead holding a Fed that could be setting more aggressive expectations in check. They have their biases and are seeking out whatever stories and data will fit into it, and their biases end up being against trying to close the unemployment gap. And thus our unemployment crisis continues on.

Mike Konczal is a Fellow at the Roosevelt Institute.

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