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.

Mishkin on Financial Instability (10/26/07)

Governor Mishkin gave a speech today on "Financial Instability and the Federal Reserve as a Liquidity Provider." In it, he reviews the history of financial panics with only passing reference to current credit market problems. He makes no mention of current economic conditions or monetary policy.

He does, however, refers for a second time to a paper he wrote ten years ago on "The Causes and Propagation of Financial Instability: Lessons for Policymakers" (pdf). He last referred to this paper in a speech on Sept 10th, eight days before the Fed surprised the market with a 50bp cut.

The paper concludes with a review of how the Fed should respond to financial instability:

One problem in deciding whether to engage in the lender-of-last resort role is to recognize that for it to be effective, it has to be implemented quickly. Less intervention is required the faster the lender-of-last-resort role is implemented....

However, the need for the lender-of-last-resort action to be quick does mean that central banks may not be able to wait until all the information is in that tells them a financial crisis is about to occur or is occurring. To wait too long to implement a lender-of last resort policy could be disastrous.

Given that credit markets have not returned to normal since the 50bp cut on Sept 18, my guess is that Mishkin will be arguing for another 50bp cut on Oct 31. I doubt, though, that the rest of the FOMC will go along with him.

Mishkin on Core vs Headline Inflation

Fed Governor Frederic Mishkin gave a speech yesterday on "Headline versus Core Inflation in the Conduct of Monetary Policy." In it, he laid out the best sound-bite argument I've yet heard for focusing on core inflation rather than headline: "Responding to headline inflation is inappropriate because it generates extensive variability in the unemployment rate." He runs through a detailed example to make the point:

Because the point about headline inflation is so important, I would like to illustrate it further with simulations of FRB/US, the model of the U.S. economy created and maintained by the staff at the Federal Reserve Board. To keep the experiments as clean as possible, I assume that the economy begins at full employment and with both headline and core inflation at desired levels. The economy is then assumed to experience a shock that raises the world price of oil about $30 per barrel over two years; the shock is assumed to slowly dissipate thereafter. In each of two scenarios, a Taylor rule is assumed to govern the response of the federal funds rate; the only difference between the two is that in one scenario the funds rate responds to core PCE inflation, while in the other it responds to headline PCE inflation. Figure 2 illustrates the results of these two scenarios:

The federal funds rate jumps higher and faster when the central bank responds to headline inflation rather than to core inflation, as would be expected (top-left panel). Likewise, responding to headline inflation pushes the unemployment rate markedly higher than otherwise in the early going (top-right panel), and produces an inflation rate that is slightly lower than otherwise, whether measured by core or headline indexes (bottom panels). More important, even for a shock as persistent as this one, the policy response under headline inflation has to be unwound in the sense that the federal funds rate must drop substantially below baseline once the first-round effects of the shock drop out of the inflation data. Responding to headline inflation is therefore inappropriate because it generates extensive variability in the unemployment rate--variability that is much more subdued when policy responds to core inflation.

This is a much more effectively way of communicating to the public why the Fed should focus on core inflation. I hope going forward they work on refining this line of line of reasoning. Maybe then mentions of core inflation won't be associated with ignorant jokes about economists who neither eat nor drive.

Recommended Reading

Interview with Frederic Mishkin
The Region - Banking and Policy Issues Magazine
September 2007

In the Lap of the Gods
Speech by Richard Fisher, President of the Dallas Fed
Greater Dallas Chamber Annual State of Technology Luncheon
October 2, 2007

Mishkin on Globalization and Rebalancing via Exchange Rates

Frederic Mishkin's gave a speech last Thursday on "Globalization, Macroeconomic Performance, and Monetary Policy," in which he talks in turn about how globalization effects inflation, output, and the "monetary transmission mechanism" (MTM; i.e. how the fed speeds up or slows down the economy). While his views on the first two topics are straightforward and unsurprising, what he says about the MTM is very very interesting.

On Inflation:

We should never forget Milton Friedman's adage that "inflation is always and everywhere a monetary phenomenon." In the long run, as long as a central bank has an independent monetary policy--that is, it is not locked into a fixed-exchange-rate regime in which its hands are tied--the rate of inflation is determined by monetary policy. ... many of the exaggerated claims that globalization has been an important factor in lowering inflation in recent years just do not hold up.

On Output:

[E]conomic globalization has the potential to be stabilizing ... The bottom line, however, is that it is not at all clear whether globalization increases or reduces output volatility.

On the Monetary Transmission Mechanism (MTM):

One of the key transmission channels of monetary policy is the exchange rate. A tightening of monetary policy, for example, raises U.S. interest rates relative to those abroad, thereby inducing upward pressure on the foreign exchange value of the dollar. An appreciation of the dollar, in turn, restrains exports (because the price of U.S. goods rises when measured in foreign currencies) and stimulates imports (because imports become cheaper in dollar terms). The resulting decrease in net exports implies a reduction in aggregate demand. In addition, an appreciation of the dollar that leads to a decline in import prices also helps restrain overall U.S. inflation.

By expanding the share of tradable goods and services in the economy, globalization might increase the role of the exchange rate as a transmission channel of monetary policy and could reduce the role of the interest rate channel. The larger the share of imports and exports in the economy, the greater the change in net exports--and, hence, in the contribution of net exports to gross domestic product (GDP) growth--for a given change in the exchange rate. In addition, the larger the share of imports in the economy, the larger should be the effect on overall CPI inflation of a given change in import prices when the exchange rate changes. (This effect is explicitly incorporated in Federal Reserve staff models of U.S. inflation, which weight import prices by the share of imports in the consumption basket.)

By the same token, the effect of the interest rate channel on overall economic activity may be diminished by greater trade integration as changes in domestic demand are offset by induced changes in imports. Guerrieri, Gust, and López-Salido (2007), for example, find that shocks to domestic demand move output less in more-open economies because they lead to larger offsetting movements in the trade balance. Supporting this result, Ihrig and others (2007) conclude that correlations between real GDP growth and real domestic demand growth have declined in recent decades in the United States and several other industrial economies.

In addition to increasing the sensitivity of the economy to changes in exchange rates, globalization may have increased the sensitivity of exchange rates to monetary policy. Over the past few decades, as capital controls have been eliminated in most major economies and the levels of home bias in portfolio investment have declined, financial markets around the world have become more tightly integrated. An implication of this financial globalization is that demand for domestic and foreign assets is likely to have become more sensitive to international differences in perceived rates of return. Accordingly, monetary policy actions may now exert more influence on exchange rates than was the case when markets were less tightly integrated and assets of different countries were perceived to be less substitutable for each other. This linkage between globalization and the effect of monetary policy on exchange rates is somewhat speculative but represents a worthwhile avenue for further research.

Now why is this so interesting? It is, after all, a fairly text-book treatment of how interest rates effect exchange rates. First, Fed speakers don't usually talk much about exchange rates, and when they do it's usually in the context of import price inflation. This speech is different. Mishkin downplays the potential for increases in import prices to be an independent source of inflation, distinct from monetary stimulus. Instead he emphasizes how exchange rate changes can affect economic growth.

This sounds like an acknowledgement and tacit endorsement that significant dollar depreciation is likely to be one of the main channels through which interest rate cuts, if needed, can effectively stimulate the economy.

Here's the thinking. Suppose the housing recession deepens, and housing prices continue to fall. Suppose also that this leads to a decline in consumer spending (which is 70% of GDP), as households respond by saving more and spending less. This is the standard scenario of the "recession is imminent" crowd. To keep the economy at full employment, the Fed has to get someone to pick up the slack. They do this by cutting interest rates until a sufficient number of people and businesses, either in the U.S. or abroad, decide they want to buy more American goods and services. The only question is, of the many ways that lower interest rates can stimulate that spending, which will be the path of least resistance. The usual housing mechanism (extra mortgage lending leading to extra housing construction) is clearly not going work this time. But getting foreigners to buy more via dollar depreciation will work, as long as that depreciation is allowed to happen. Perhaps this speech is a signal that the Fed is laying the groundwork for that possibility. It's perhaps no coincidence that Mishkin's next speech is on Systemic Risk, which would help to lay even more of that groundwork.


This is going to be an interesting one to watch play out.

Follow Mishkin

Frederic Mishkin has only been on the Board of Governors for about a year now, but in that time he's become an incredibly good barometer of Fed thinking. If you were trying to predict the outcome of the Sept 18th FOMC meeting, and all you had done was read Mishkin, you likely would have nailed it.

I've linked below to Mishkin's most relevant speeches since joining the Fed. The paper he gave at Jackson Hole on Housing and the Monetary Transmission Mechanism is the most important by far. It's long (55 pages) and a bit wonky, but well-worth perusing.

March 23, 2007: Inflation Dynamics, 8 pgs
April 10, 2007: Monetary Policy and the Dual Mandate, 4 pgs
May 24, 2007: Estimating Potential Output, 7 pgs
June 23, 2007: Globalization and Financial Development, 8 pgs
Sept 1, 2007: Housing and the Monetary Transmission Mechanism, 55pgs
Sept 10, 2007: Outlook and Risks for the U.S. Economy, 6 pgs
Sept 21, 2007: Will Monetary Policy Become More of a Science? 46 pgs
Sept 27, 2007: Globalization, Macroeconomic Performance, and Monetary Policy, 10 pgs

What The Fed Should Do (Mishkin 1997 & 2007)

Frederic Mishkin, who, along with Don Kohn and Ben Bernanke, is one of the major macroeconomic heavyweights on the Board of Governors, recently gave a speech on the Outlook and Risks for the U.S. Economy in which he highlighted a paper he wrote in 1997, when he was Director of Research for the FRB of New York.

That paper (The Causes and Propagation of Financial Instability: Lessons for Policymakers (pdf)) lays out the circumstances under which asymmetric information problems can magnify and multiply into a full-blown financial crisis. The bad news is that those preconditions describe the current situation disturbingly well. The good news is that Mishkin tells us what the Fed should do in response.

Here's the abridged version of Mishkin's top four causes of financial instability:

Four factors typically help initiate financial instability:

(1) increases in interest rates,
(2) a deterioration in bank balance sheets,
(3) negative shocks to nonbank balance sheets, and
(4) increases in uncertainty.

Countries often begin experiencing major bouts of financial instability when domestic interest rates begin to rise, often with the rise initiated by interest rate increases abroad. For example, most financial crises in the United States in the nineteenth and early twentieth centuries began with a sharp rise in interest rates that followed interest rate increases in the London markets. ... these rises in interest rates increased adverse selection problems in the credit markets. The rise in interest rates also increased moral hazard problems because the resulting decrease in cash flow hurt the balance sheets of nonbank firms. In addition, the increase in interest rates weakened bank balance sheets because of banks’ maturity mismatch....

Figure 1: Propagation of Financial Instability in Industrialized Countries

Also characteristic of the early stages of financial instability is a deterioration in bank balance sheets because of risky loans that have turned sour. In the recent Mexican episode, the source of these weakened balance sheets was financial liberalization that led to a rapid acceleration of bank lending, in which bank credit to the private nonfinancial business sector rose from 10 percent of GDP in 1988 to over 40 percent in 1994. This lending boom, which stressed the screening and monitoring facilities of the Mexican banks, along with the inability of the National Banking Commission in Mexico to adequately supervise these new lending activities, led to growing loan losses in the banking sector. ... The deterioration in bank balance sheets decreased the ability of the banks to lend because efforts to improve their capital ratios required retrenchment on lending.

Stock market crashes are also typically associated with financial instability.... The declining net worth of nonfinancial firms then increased adverse selection and moral hazard problems in financial markets because the effective collateral in the firms had decreased, while the decline in net worth meant that the incentives for borrowers to take on risk at the expense of the lender had increased.

The fourth factor that frequently appears when there is financial instability is an increase in uncertainty, whether because an economy is already in recession, or because a major financial or nonfinancial firm goes bankrupt, or because of increased political instability.... Increases in uncertainty make it harder for financial markets to process information, thereby increasing adverse selection and moral hazard problems and causing a decline in lending and economic activity.

If any of the four factors in the top row of the figure occurs, it can promote financial instability. If all of these factors occur at the same time and are large, the situation is likely to escalate into a full-scale financial crisis, with much greater negative effects on the real economy.

That was what he said ten years ago. Now here's what he said last week:

...an increase in uncertainty and concerns about the quality of information can lead investors to pull back from financial markets and restrict productive lending--with potentially adverse implications for real activity. That is essentially the story I laid out in a paper delivered at the Kansas City Fed’s Jackson Hole conference about ten years ago.⁷ In my view, such an increase in uncertainty is an important part of what we have observed recently.

That takes care of the diagnosis; now for the prescription (again from 1997):

The asymmetric information analysis thus suggests that a lender-of-last-resort role may be necessary to provide liquidity to nonbanking sectors of the financial system in which asymmetric information problems have developed....

One problem in deciding whether to engage in the lender-of-last resort role is to recognize that for it to be effective, it has to be implemented quickly. Less intervention is required the faster the lender-of-last-resort role is implemented because once market participants know that liquidity is being injected into the system, uncertainty in the financial markets will decrease. Thus, the Federal Reserve’s actions during the stock market crash of 1987 are a textbook case of how a lender-of-last-resort role can be performed successfully. The Fed’s action was immediate, with an announcement that operated to decrease uncertainty in the marketplace. Reserves were injected into the system, but once the crisis was over, they were withdrawn. Not only was a financial crisis averted, but also the inflationary consequences of this exercise of the lender-of-last resort role were quite small.

However, the need for the lender-of-last-resort action to be quick does mean that central banks may not be able to wait until all the information is in that tells them a financial crisis is about to occur or is occurring. To wait too long to implement a lender-of last resort policy could be disastrous.

Sounds to me like a 50bp cut on Sept 18, with a neutral bias after that, which implies they'll have a hiking bias once the downside risks from the financial market turmoil recede.