Mishkin Says He Really Is Neutral...

Governor Mishkin gave a surprisingly hawkish speech yesterday on "Financial Instability and Monetary Policy."

Mishkin has been the most vocal advocate on the FOMC for significant preemtive rate cuts. He's been arguing that financial market instability has the potential to significantly harm real economic growth and, if this were to happen while financial markets were still not functioning properly, that slowdown could spiral into a deep recession that would be difficult to reverse once it took hold. He therefore advocated aggressive rate cuts in advance of any evidence of a growth slowdown. That argument has gotten the FOMC to cut by 75 bps, even though many members sounded reluctant to cut preemptively prior to the Sept 18th meeting.

In the FOMC statement after the Oct 31st meeting, the Fed sounded like they were done cutting rates preemptively, saying that growth risks were now balanced with inflation concerns. But was this a message that everyone on the FOMC really believed, or was it a compromise that was required to convinced some of the more hawkish members to go along with the 25bp cut? I had guessed the later, given how vocal some members had been about downside risks to growth prior to the meeting. Now we have Mishkin, one of the FOMC's chief doves, saying they really are neutral:

In circumstances when the risk of particularly bad economic outcomes is very real, a central bank may want to buy some insurance and, so to speak, "get ahead of the curve"--that is, ease policy more than it otherwise would have simply on the basis of its modal economic outlook. However, because monetary policy makers can never be certain of the amount of policy easing that is needed to forestall the adverse effects of disruptions in financial markets, decisive policy actions may, from time to time, go too far and thus produce unwelcome inflationary pressures. .... If, in their quest to reduce macroeconomic risk, policymakers overshoot and ease policy too much, they need to be willing to expeditiously remove at least part of that ease before inflationary pressures become a threat.

What I just said should serve as a framework for understanding the recent decisions of the Federal Reserve to ease policy, first by 50 basis points on September 18 and then by another 25 basis points last week. The first action was larger than markets expected at the time--indeed, quotes from the federal funds futures market as well as survey data indicated that most investors had anticipated a cut of only 25 basis points in the target federal funds rate ahead of that meeting. As reported in the minutes, the Federal Open Market Committee (FOMC) judged that a policy easing of 50 basis points was appropriate to help offset the effects of tighter financial conditions on the economic outlook. Had the FOMC not eased policy, it would have faced a risk that the tightening of credit conditions and an intensifying housing correction would lead to significant broader weakness in output and employment. In addition, it would have faced the possibility that the impaired functioning of financial markets would persist for some time or worsen, which would create an adverse feedback loop not dissimilar to what I earlier called macroeconomic risk. The cut of 50 basis points at that meeting was the most prudent action from a macroeconomic standpoint, even given the Federal Reserve's objective of price stability. Indeed, with economic growth likely to run below its potential for a while and with incoming inflation data to the favorable side, the easing of policy, even if substantial, seemed unlikely to affect adversely the outlook for inflation.

At the FOMC meeting last week, the federal funds rate target was lowered by another 25 basis points. Our economy grew at a solid pace in the third quarter and was boosted importantly by personal consumption and business expenditures, an indication of considerable underlying strength in spending before the recent financial turbulence. However, the pace of economic expansion is expected to slow in the near term, largely because of the intensification of the housing correction. The combined 75 basis points of policy easing put in place at the past two meetings should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and should help promote moderate growth over time.

Going into the meeting, I was comforted by the lack of direct evidence to date of serious spillovers of the housing weakness and of tighter credit conditions on the broader economy. But with an unchanged policy interest rate, I saw downside risks to the outlook for growth. I was mindful, in particular, of the risk that still-fragile financial markets could be particularly exposed to potential adverse news on the housing situation, or on the macroeconomy more generally, and that renewed strains in financial markets could feed back adversely on economic performance. My vote to ease policy at the meeting was motivated by my wish to reduce those risks. The FOMC perhaps could have waited for more clarity and left policy unchanged last week, but I believe that the potential costs of inaction outweighed the benefits, especially because, should the easing eventually appear to have been unnecessary, it could be removed.

Overall, I think that the cumulative policy easing the FOMC put in place at its past two meetings reduced significantly the downside risks to growth so that those risks are now balanced by the upside risks to inflation. In these circumstances, I will want to carefully assess incoming data and gauge the effects of financial and other developments on economic prospects before considering further policy action.

That's about as hawkish as I've heard Mishkin be since the credit turmoil began. This new hawkishness from one of the Fed's main doves makes it significantly less likely that they'll cut again on December 11. Clearly this neutral stance means they won't cut if growth doesn't slow. But both the Fed and most outside observers expect growth to decelerate significantly in Q4. So here's the big question: What will the Fed do if growth slows as expected? Are they neutral relative to current growth, or relative to their outlook for growth? That is, will they cut if growth slows at all, or only if growth slows more than expected. I bet it's more the former, which isn't really a neutral stance at all.