Who Do They Think Theyre Kidding?
Over the last several days, much-publicized comments by FOMC Governor Kevin Warsh, later echoed by Dallas Fed President Fisher, have spoken about the possibility that policy accommodation might be removed with "alacrity" (Fisher's word): the "speed and force of the action ahead may bear some corresponding symmetry to the path that preceded it" (Warsh's phrase).
Warsh's remarks have been widely reported, and are clearly an important part of the speech (which, however, is more nuanced than that and definitely worth reading). Fisher's comments were more direct, and highlighted on the Dallas Fed's website: "I am not alone on this front. I have faith my colleagues on the Federal Open Market Committee will stand and deliver in a timely way. And I expect that when it comes time to tighten monetary policy, my colleagues and I will move with an alacrity that, if needed, will be equal in speed and intensity to that with which we pursued monetary accommodation."
I will take the "over" on the time required to remove policy accommodation. While there are reasons to laud this spirit from a couple of feisty policymakers, there are two reasons I do not believe they will effect the eventual tightening of monetary policy with the severity they seem to promise.
The first problem is the shape of the monetary policy reaction function. Historically, the Federal Reserve has been much more aggressive in responding to negative growth shocks than to positive growth shocks or to positive inflation shocks. This historical tendency was established firmly over the last 22 years by former Chairman Alan Greenspan (as I discussed in my book), who got the opposite DNA of most central bankers and feared recession more than inflation. But there's also a somewhat natural reason for this bias, and that's that economists understand growth shocks much more than they understand inflation shocks and the interplay of growth and inflation. If that's the case, then it is natural to respond more slowly to inflation shocks than to growth shocks. But in any event, if the Bernanke Fed is making a conscious effort to balance its response to inflation with its response to growth, that's a positive development and should be applauded.
However, the second problem is more intractable, and that is the necessary timing of the reaction function. We know about growth lags. We don't know nearly as much about inflation lags. But, in general, inflation responds more slowly than growth to changes in monetary policy. Moreover, there is an additional lag due to the necessity of getting a good measurement of inflation, since our intuition about inflation tends to be systematically wrong due to cognitive biases.
This is the big problem in monetary policy, and we can't do anything about it. Policymakers control one variable, liquidity, which affects growth and inflation in opposite ways but with different amplitudes and lags. So, in order to restrain inflation in a year (for example) the Fed needs to tighten now, but that will start dragging on growth in six months. This is one reason the FOMC always waits until Unemployment has been falling for a while before they even think about tightening.
It is also, by the way, a good argument for letting the natural cycle handle most of the adjustment, since the natural cycle will tend to evolve the most efficient (if occasionally brutal) solution. But I digress.
Finally, we can talk all we want about removing accommodation, but that talk rings hollow when bank credit is contracting, which it is - and the picture keeps getting worse. Bank credit has grown only 0.1% over the last year, which is the smallest gain on record and includes the jump from the reclassification of Morgan Stanley and Goldman as commercial banks. Without that effect (which vanishes from the data in two weeks, whereupon you will suddenly see lots of people writing about the unprecedented decline in bank credit), commercial bank credit has contracted 2.8% over the last year, and 10.6% over the last 13 weeks. Monetary policy is, in fact, already very tight.
So, what are these guys up to? Who are they trying to kid? Here are some possibilities:
- Perhaps they are trying to talk down the stock market, which is very frothy. Clearly, at least some in the Federal Reserve think they've done most of the heavy lifting of surviving the serial bubbles problem and don't want another one...but if that's what Warsh and Fisher are trying to do, then it's not working! Indeed, the stock market's lack of response to these threats is another piece of evidence that a bubble is forming already.
- Maybe they are trying to add some stochastic uncertainty into investors' calculations. That is, if you make people think you just might be crazy enough to do something really nutty like tightening policy when bank credit is already collapsing, perhaps those investors will demand a margin of safety. This would be a good plan, but it would reverse a couple decades of glasnost at the Fed that I believe they generally think has been a good thing.
- It could be that the Fed wants to start to transition the bond market to price in a more aggressive future policy path, so it will be less disruptive when it does happen. This is a good idea, but given how far away and unlikely an aggressive policy tightening is, the timing of this chatter is curious.
- Perhaps they actually believe what they're saying, and think the Fed needs to hike rates aggressively with inflation still heading down and unemployment up. If so, then fire them, and quickly!
Warsh does warn that when 'unusual and exigent circumstances' no longer exist, then the exceptional actions implemented by the Fed under their opportunistic interpretation of section 13(3) of the Federal Reserve Act are no longer permissible and must be unwound. Given the generous interpretation by the FOMC of that statute so far, however, it seems to me that we shouldn't hold our breaths that the Committee will stick to the spirit of the rule.
To put it bluntly - I don't know what these guys are up to. If you read the entire speech it seems to me that Warsh is trying to cover all bases and the media simply cherry-picked the scary stuff. But Fisher, since he did the highlighting himself on the Dallas Fed website, is clearly sending a message and that increases the chance that Warsh is sending that same message. From a trading perspective, it makes sense to take these comments into account and to trade defensively. From an investing perspective, listening to the Federal Reserve rather than listening to the data themselves is usually not particularly productive anyway.