A Response to Neel Kashkari’s FOMC Dissents
Note: Before reading this post, please read Minneapolis Fed President Neel Kashkari’s blog post published on June 16, regarding his dissenting vote on the FOMC’s most recent decision to raise the federal funds target range by 25 basis points: https://medium.com/@neelkashkari/why-i-dissented-again-b8579ab664b7
Neel Kashkari has cast the lone dissenting vote for both of the Fed’s rate hikes in 2017. His post-meeting blog posts on Medium have been helpful in understanding the reasoning behind his dissents. While he makes some good points, there are some key flaws in his analysis. In this post, I attempt to break down his analysis and interpretation of the data he presents, as well as his own personal reasoning for voting to hold off on raising rates. (Before I go any further, I would like to state that I have only one year’s knowledge of undergraduate economics under my belt, and my knowledge of the intricacies and nuances of monetary policy is limited. All of the logic and reasoning I present in this blog I believe to be true, but I acknowledge that some of it may be incorrect.)
In his opening, Kashkari tries to reconcile the tightness of the labor market and lower than expected inflation. Kashkari is unconcerned with the former because of the latter, but I personally find the current employment data to be somewhat concerning. The sharp drop in unemployment in recent months, as well as the rise in the labor force participation rate and employment-population rate, is evidence that the labor market is now quite tight. Both the headline unemployment rate and the broader U6 measure of unemployment are currently at pre-crisis levels, although both the labor force participation rate and the employment-population rate are still below those levels. However, I believe using pre-crisis levels as a target for such rates is dangerous. Based on how severe the Great Recession was, we can tell that the pre-crisis economy was overheating significantly. Although it may be politically unpopular, I think the Fed should be concerned that the labor market is performing too well, as it may be an indicator that the economy is overheating.
Although Kashkari doesn’t seem concerned about employment, he seems to be overly concerned about recent inflation readings. Kashkari’s analysis makes it seem as though the US faces significant deflationary headwinds when the data actually shows that inflation has been quite stable, albeit slightly below the Fed’s target. According to the PCE price index, which is the Fed’s preferred measure of inflation, core inflation has hovered around 1.5% for several years now. A sudden collapse in headline inflation in 2014 was the only alarming deflationary sign in recent years. Although headline inflation fell sharply, core inflation held up quite well. At the same time, crude oil prices fell from a peak of ~$105 in June 2014 to a low of ~$47 in January 2015, representing a 50% fall.¹ Since core inflation remained strong, we can deduce that the fall in headline inflation was due largely to deflationary pressure on petroleum-based fuel prices, which are excluded from the core inflation readings. I think the Fed should be a bit more generous in their adherence to their inflation target. It’s inconceivable that there is really much of a difference between 1.5% inflation and 2% inflation. This begs the question: how close must inflation be to 2% for the Fed to consider its price stability objective as met? In addition, the severity of the 2008 recession has left a long-lasting impact on consumer spending habits, causing consumers to be much more cautious in their spending.² The Fed should be cognizant of the limitations of monetary policy in addressing such issues, as well as some of the potential adverse effects that could arise from trying to address such issues with monetary policy.
Measures of inflation expectations show no signs of a de-anchoring from the Fed’s target. Both measures of survey-based inflation expectations are above the Fed’s target of 2%, and both measures of market-based inflation hover close to 2%. Although most of these measures have been trending down in recent years, it should be noted that they began trending down shortly after then-FOMC Chairman Ben Bernanke established a nominal inflation target of 2% in January 2012.³ In this context, it should be seen as a positive sign that inflation expectations are continually moving closer to the Fed’s nominal inflation target.
Although Kashkari would prefer to hold off on raising rates until the data definitively shows that the US economy is at full capacity, it would be prudent for the Fed to begin acting before they absolutely have to. Janet Yellen has argued that the Fed should be “ahead of the curve”⁴ with monetary policy. This is true both because monetary policy acts with a lag, and since it is better to be ahead of the curve than to risk falling behind it.
Paul Volcker’s response to stagflation in the 1970s is a prime example of the Fed successfully staying ahead of the curve. After aggressively raising rates and curtailing the rise of inflation, Volcker began lowering the federal funds rate in August 1981, even though inflation was still at 8.67%, well above its historical average.⁵ Despite high inflation, the Fed funds rate decreases did not hamper the return of inflation to low levels. The reason for this was that even though rates were falling, they were still quite high relative to historical levels, which kept inflation in check even as rates fell.⁶ Today, we see almost a perfectly inverse scenario. Usually during episodes of low inflation, tightening monetary policy is one of the last things a central banker would think of. However, monetary conditions have been very simulative for several years now. Even if the federal funds rate rises by 25 basis points, it is still very low relative to historical levels.⁷
Towards the end of his blog, Kashkari asserts that monetary policy is at present only slightly simulative. He uses the concept of the neutral real rate to support his assertion. I am not a mathematician, and I do not know how he arrived at this estimate, so I cannot refute his claim empirically. However, from a purely logical standpoint, his claim that the current neutral real rate of interest is 0% seems fundamentally flawed. At present, the US economy is doing fairly well, by most metrics. The idea that borrowed capital should have no real cost in order to keep our economy on an even keel seems highly flawed. If the US economy were as strong as it appears, firms should be able to pay a real price for borrowed capital without causing a cyclical slowdown in economic growth. However, even using Kashkari’s own estimate of a zero or slightly negative real rate, that would leave the pre-meeting federal funds rate between 50 and 75 basis points simulative. This means that the Fed could hike rates by 25 basis points and still be slightly accommodative. Given the current strength of the labor market and the amount by which inflation is undershooting the Fed’s target, this seems quite appropriate.
Another important topic I want to touch upon is financial stability. As Kashkari explained in another blog post,⁸ it is difficult for the Fed both to spot a bubble, and also to take action once it has identified one. I agree with him on this. Bubbles are very tricky to deal with, and intervention by the Fed in an effort to prevent or pop bubbles could have unintended consequences, such as an unwarranted slowdown of the broader economy. However, there is a difference between the Fed attempting to pop a bubble and the Fed ensuring that its actions do not encourage the formation of a bubble. As of May 2017, the Fed’s balance sheet, which consists primarily of Treasury securities and mortgage-backed securities, stands at roughly $4.5 trillion.⁹ This has helped suppress yields on longer-term Treasury bonds and similar long-term debt instruments. However, these policies, as well as similar ongoing quantitative easing programs by the European Central Bank and the Bank of Japan, have forced investors looking for decent returns into more risky assets, such as commercial paper or emerging market debt.¹⁰ Some have expressed concerns that suppressed yields and elevated prices on such debt instruments looks concerningly like a bubble.¹¹ However, this is a bubble the Fed is able to target directly. By starting the process of unwinding their balance sheet, the Fed can allow yields on longer-term Treasury securities to rise, which will help to ease the search for yield that many investors are undertaking. On this issue, I see eye-to-eye with Kashkari. I fully support his efforts to begin the process of unwinding the Fed’s balance sheet. However, where I disagree with him is in my belief that the Fed should also be trying to raise the federal funds rate.
The federal funds rate is not as effective of a monetary policy tool as it once was. This is primarily due to the effects of the Fed’s bloated balance sheet. The sheer volume of assets purchased by the Fed through their three rounds of quantitative easing flooded the banking system with reserves. While the intention was for banks to use those reserves to make loans, data shows that banks have chosen to hold a majority of that capital as excess reserves.¹² With this boost in reserves, banks now rarely have a need to borrow federal funds in order to meet reserve requirements. As a result, federal funds borrowing plummeted after 2008.¹³ Since the federal funds market has become less relevant to banks’ operations, the federal funds rate now has less bearing on other key interest rates. This can be seen in how other key rates, primarily longer-term interest rates, have failed to track the recent upwards movement of the federal funds rate. For example, following a brief spike after the 2016 election, mortgage rates and long-term Treasury yields have consistently declined throughout 2017, even as the federal funds rate rose.¹⁴ However, there is evidence that the federal funds rate still has a bearing on short-term interest rates. For example, the 1-year treasury yield has closely tracked movements in the federal funds rate in recent years.¹⁵ Such a disparity in short-term versus long-term rate shifts could have longer-term consequences, such as an inversion of the yield curve. It is for this reason that I believe the Fed needs to raise the federal funds rate, while simultaneously unwinding their balance sheet.
Footnotes:
1: FRED: WTISPLC data set
2: http://www.pewsocialtrends.org/2010/06/30/iv-the-new-frugality/
3: https://www.federalreserve.gov/newsevents/pressreleases/monetary20120125c.htm
4: https://www.nafcu.org/News/2017_News/April/Yellen__Fed_should_be__ahead_of_the_curve_/
5: FRED: PCEPI & FEDFUNDS data sets
6: FRED: FEDFUNDS data set
7: FRED: DFEDTAR data set. Before this most recent hike, the fed funds rate was below any pre-crisis levels. Lowest pre-crisis fed funds target rate was 1% from June 2003 to June 2004
8: https://medium.com/@neelkashkari/monetary-policy-and-bubbles-3208d4d570ee
9: www.federalreserve.gov/monetarypolicy/files/quarterly_balance_sheet_developments_report_201705.pdf
10: https://www.wsj.com/articles/central-banks-put-squeeze-on-sovereign-debt-market-1467847016
11: http://www.cnbc.com/2015/06/11/how-the-fed-screwed-up-the-bond-market.html
12: FRED: WALCL, EXCSRESNS, & REQRESNSW data sets
13: http://libertystreeteconomics.newyorkfed.org/2013/12/whos-lending-in-the-fed-funds-market.html
14: FRED: DGS10, DGS30, & MORTGAGE30US data sets
15: FRED: FEDFUNDS & DGS1 data sets
Thanks to Frank Chaparro for stylistic edits. https://twitter.com/fintechfrank
