When hawks cry

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Sep 11th 2008 | WASHINGTON, DC
From The Economist print edition

How America’s central bank copes with an unusual level of dissent


BEN BERNANKE, the chairman of the Federal Reserve, has a lot on his plate these days, including a financial crisis, a probable recession, and the worst inflation in 17 years. What is more, he is tackling it with a fractious team of policymakers.

The contingent of inflation hawks on the Federal Open Market Committee (FOMC) is one of the largest and most vocal in memory. The committee, made up of governors and regional bank presidents, has voted on interest rates eight times since the end of last September. All featured at least one dissenting vote and, except for one, they were for higher interest rates. At least six of the 12 bank presidents (of whom five vote in any given year) have expressed discomfort with the current, low level of rates. Ahead of the Fed’s August 5th policy meeting, three banks requested a quarter-point increase in the Fed’s discount rate. They did not get it. But it was a sign of what they want.

The FOMC has so far refused to yield to such internal pressure. Mr Bernanke would sooner suffer dissent than placate the hawks with what he thought was a premature rate increase. The signs are that the Fed will maintain the federal funds rate at 2% when it meets on September 16th. There could even be a rare show of harmony, given that the inflationary threat from oil prices and the dollar may be receding.

The hawks’ bigger influence is on how the Fed talks. Mr Bernanke has made Fed deliberations more democratic and strives to incorporate the breadth of his colleagues’ views in official announcements. In a process that began shortly before he took office, a draft of the post-meeting statement is e-mailed a week before each meeting to FOMC members, who are asked to comment if they do not think it spans the “plausible range” of committee views. Anywhere from zero to four typically do, sometimes resulting in a new draft. During meetings, Mr Bernanke sums up the views of his colleagues before stating his own. At times, this can send misleading signals about interest rates. Statements released last month, and in August and October last year, emphasised concerns about inflation at a time of deepening economic distress. Mr Bernanke has sought to reduce the confusion by asserting his own views in public more often.

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Bridging these divergent views is tricky because many of the hawks do not just differ in their outlooks, but in how monetary policy works. The conventional view, shared by Mr Bernanke, Donald Kohn, his influential vice-chairman, and their professional staff, is that monetary policy affects inflation via its impact on the real economy. Higher interest rates reduce demand relative to the economy’s potential to supply goods and services. Reduce it enough, and unused slack will accumulate, forcing firms and workers to compete for scarce customers and jobs by lowering prices and wages. The opposite happens when demand rises relative to supply. This relationship is captured in the Phillips curve, which shows inflation falling when unemployment is above its natural rate. In this view, it does not matter whether it is monetary policy or a credit crunch that raises unemployment: both put downward pressure on inflation. What is more, Mr Bernanke and his colleagues reckon today’s low fed funds rate is merely offsetting tighter financial conditions from the credit crunch.

The hawks, by contrast, think that unemployment and other measures of “economic slack” have limited bearing on the transmission of monetary policy. Fed actions affect inflation primarily by altering inflation expectations. They worry that a low funds rate in itself threatens to lift inflation, and rising unemployment and the credit crunch will do little to contain it.

The divide inside today’s FOMC recalls the “freshwater-saltwater” split in macroeconomics in the 1970s and 1980s, when inland scholars such as those at the University of Minnesota challenged the Phillips-curve advocates at coastal universities like the Massachusetts Institute of Technology over their sympathy for activist policymaking. Appropriately, the latest challenge originated with research at the Minneapolis Fed earlier this decade that found no relationship between unemployment and inflation. The most outspoken hawk today is Jeffrey Lacker, a University of Wisconsin graduate who now heads the Richmond Fed. He dissented four times in 2006 and in June criticised the Fed’s expansion of lending to banks as risking both moral hazard and the Fed’s independence.

Although some hawks rile their colleagues with the rigidity of their views, they are not a threat to Mr Bernanke’s leadership. For one thing, his fellow governors in Washington, DC, are united behind him. For another, the hawks are grateful for being encouraged to air their disagreements. The hawkish chatter may at times muddle the Fed’s message, but it probably means the FOMC is working as it should.