Narayana Kocherlakota started out as the intellectual leader of the Federal Reserve’s hawkish bloc. While Richard Fisher and Thomas Hoenig were making what amounted to irritable noises, Kocherlakota was doing some pretty sophisticated looking analysis in support of a hawkish position. But a funny thing happened. As new data came in which made it clear that his initial analysis had been mistaken, Kocherlakota changed his mind to mark his beliefs to market. Even better, as a speech he delivered in Duluth yesterday makes clear he’s shifting his entire analytical framework to align it with his current understanding of what’s going on:
In light of the unusually large macroeconomic shock, I believe that it is misleading to assess the FOMC’s actions by comparing its current choices to policy steps taken over the past 30 years. Instead, we have to assess monetary policy by comparing the economy’s performance relative to the FOMC’s goals of price stability and maximum employment. In particular, if the FOMC’s policy is too accommodative, that should manifest itself in inflation above the Fed’s target of 2 percent. This has not been true over the past year: Personal consumption expenditure inflation—including food and energy—is running closer to 1.5 percent than the Fed’s target of 2 percent.But this comparison using inflation over the past year is at best incomplete. Current monetary policy is typically thought to affect inflation with a one- to two-year lag. This means that we should always judge the appropriateness of current monetary policy using our best possible forecast of inflation, not current inflation. Along those lines, most FOMC participants expect that inflation will remain at or below 2 percent over the next one to two years. Given how high unemployment is expected to remain over the next few years, these inflation forecasts suggest that monetary policy is, if anything, too tight, not too easy.
This is a model of how public servants and public intellectuals should act. On politically controversial subjects, there’s always a sizable constituency for basically anything you want to say. So the temptation exists to simply stick with previous positions and dedicate your energy to explaining away adverse data. Changing your mind is tough but necessary and important. My own path on this topic has come from a different starting point—from an underestimation of the tools potentially at the Fed’s disposal—but ultimately arrived at the same landing point as Kocherlakota. It doesn’t make sense to judge the stance of monetary policy in terms of how much “stuff” the Fed is “doing.” Rather, you have to look at nominal forecasts. Policies that are consistent with forecasts of low nominal growth are, as such, tight policies. You’ll know monetary policy is loose when nominal forecasts start rising. Talking about how the Fed is “doing a lot” is a dangerous distraction from that bottom line.
