Beware: The Hawks Attack

I understand if few of you know who Charles Plosser is. Most of you don’t even care. Maybe after you understand what he said in a speech yesterday you’ll pay attention.

Plosser is the head of the Philadelphia Federal Reserve Bank. Mercifully he will not have a vote on the Fed’s monetary policy setting committee until 2011, because he is a committed interest rate hawk. He wants to raise rates sooner rather than later, if not now.

His argument is straightforward: the economy is now growing, the crisis is dealt with and we should now start to return Fed policy to its anti-inflation task. That implies undoing much, if not all, the extraordinary ‘pump priming’ the Fed has engaged in over the last year or so. This should be done with urgency and aggression since the threat from a surge in inflation is deemed to be very high.

Plosser uses all sorts of sporting analogies and along the way seems to conflate ice hockey and monetary policy as only a true ‘jock’ could. Generally I find discussing policy issues in terms of ice hockey unhelpful, but apparently Plosser thinks otherwise.

Lets see what he said:

1. The economy is now safely on a growth track. He expects GDP to grow 3% in the fourth quarter and by that same amount all nest year.
2. He acknowledges that the stimulus is wearing off and that the inventory adjustment is fading, but he sees consumption as robust enough to carry the load along with a slow bounce back in real estate.
3. He talks about unemployment in what I consider glib terms. He sees it as lagging the recovery – it always does – and so the fact that it is above 10% and was rising until very recently is of no real concern. It will come back down in due course. Besides there’s not much we can do about it.
4. There is no immediate likelihood of either deflation or inflation. Both are under control because economic conditions are generally benign currently.
5. But: inflation is a very real threat in the medium term – two to three years hence. This is because of all that cash sloshing about the economy as a result of the Fed’s various bail out and monetary stimulus actions. This cash represents a real threat since it cannot be absorbed by growth and so will find its way into prices. Hence inflation.
6. The argument that inflation is not an issue because of all the slack in the economy is dismissed on two grounds: first it is difficult to measure ‘slack’; and second, we have had high inflation during periods of high slack anyway – e.g. the 1970’s.
7. Apparently the markets agree with this assessment and are concerned about inflation down the road – the highly sloped yield curve suggests a high inflation risk premium for five year and beyond money.
8. So … drum rolls please … the Fed should begin to rein in its activities; reduce the cash in the system; and raise interest rates. This will get it back to its anti-inflation stance [a.k.a. ‘encouraging price stability’] which Plosser says is the Fed’s raison d’etre.

Where do I begin?

He may be right about GDP growth. I think he is at the higher end of the optimistic forecast range, especially for next year, but let’s allow him his 3% growth rate.

He slips right by unemployment as if it is an awkward side issue. While he agrees that it is unfortunately high, he doesn’t perceive the need for any action – unemployment will take care of itself in due course. In this he is correct. What he misses is any notion of whether that timing is acceptable – do we really want high unemployment for the next five years? And, he fails to address the obvious problem that high unemployment could undermine growth through its sapping at both consumer confidence, and more concretely, at wages available for spending. He makes no comment on either of these issues and blithley sidelines the entire jobs discussion as being secondary.

I have warned you about this syndrome before. Its the ‘sound central banker syndrome’. They just love being seen as scrooges. It gives them a puritanical sense of rectitude: they are the bulwark against the follies of mere mortals like you and me who want a more secure future along with a job. In the eyes of central bankers the only security worth fighting for is ‘price stability’. Low inflation. Once this is assured the economy will take care of itself.

This is very laudable. And I agree that stable inflation over the long haul is vital to economic health.

But we don’t have an inflationary threat. There is none. Nada.

This is where Plosser’s ideology takes over.

You see, he’s a Chicago school guy. A proud one too. To those folks economics is really simple: scale back the government so it doesn’t get in anyone’s way; abolish all regulation; let the markets rip; and keep prices stable. Oh, and by the way, it is the Chicago school that teaches that there is no involuntary unemployment. If only those workers would accept lower wages they’d all have jobs.

Given this ideology it is hardly surprising that Plosser neglects to mention that the Fed has two goals in its Congressionally provided charter: price stability and low unemployment.

Conservatives do this all the time: they look at the part of the charter or article they prefer and ignore the other part[s]. They do that with the Second Amendment all the time – the constitution says absolutely nothing about the right to bear arms outside of the context of a ‘well armed militia’. And the Fed is supposed to put equal emphasis on unemployment and inflation.

Finally, Plosser’s notion that a steep yield curve supports his argument is a common hawk position. It fails the test of even mild scrutiny. Medium and long term interest rates are now back to more normal ranges. They are no higher than they usually are in periods of GDP expansion. They are certainly well in line with rates back in the earlier 2000’s. The steepness of the yield curve comes not from high long term rates – which is Plosser’s argument – but from historically low short term rates. Why are those short term rates so low? Hmmm. Banking crisis? Recession? Credit market chaos?

So Plosser’s entire discussion is supposed to lad us to the point of agreeing that raising rates is now, or soon will be, an imperative. But nothing in his argument, not even all that ice hockey jazz, actually supports him. His is an argument looking for a problem.

Presently all the analytical signs indicate that the Fed should keep rates low. Possibly for another year. The so-called Taylor Rule, the rule of thumb analysis that balance the Fed’s two targets of inflation and unemployment, produces a negative Fed Funds rate, as low as -6%, still. This may be off the mark, but at least is has an air of analytical rigor to it. Plosser offers no such rigor, simply an ideological viewpoint. Given a choice between analysis and Chicago school ideology I would prefer to put my money on analysis.

Keep rates down for a while yet.

Are there risks to this? Absolutely. The biggest being that our hyperactive banks will use those low rates to gamble and thus inflate a new bubble. There are signs that this is already happening in emerging market stock and asset prices.

But the downside risk to low rates is more than offset by the damage a rate hike would inflict on our economy.

If you believe, as I do, that growth is fragile, then a rate hike runs the risk of plunging us back into recession. There is too much rubbish still cluttering up bank balance sheets and more is on its way via the commercial real estate market. A second recession could undo all the good work we have done in patching up [but not fixing] the banks. So a double dip recession represents, to me at least, a far more dire threat, than that of excess liquidity slopping about global markets.

Basically it all comes down to whether you think unemployment matters enough to be a focus of policy.

To me it does.

To hawks like Plosser it doesn’t.

So beware: the hawks attack!