The FOMC minutes were simply fascinating. The discussion of the economic situation was markedly downbeat, even before the latest employment report, yet the final outcome of the meeting – the FOMC statement and Federal Reserve Chairman Ben Bernanke’s subsequent press conference – seemed to clearly indicate that, barring an outright return to the threat of deflation, the Fed saw its job as done. How can we reconcile these two positions? Presumably the faction leaning more toward additional easing is relatively small, while the majority believes either they have already gone too far or that further policy is ineffectual. Bernanke seemed to place himself in the latter category during the press conference. Is that really where he stands? This apparent divergence of views on the FOMC will bring extra attention to Bernanke’s testimony today on Capitol Hill.
Begin with the economic situation as seen from Constitution Ave. A host of “temporary factors” are weighing on the economy:
… including the global supply chain disruptions in the wake of the Japanese earthquake, the unusually severe weather in some parts of the United States, a drop in defense spending, and the effects of increases in oil and other commodity prices this year on household purchasing power and spending.
Still, better times are on the horizon:
Participants expected that the expansion would gain strength as the influence of these temporary factors waned.
I wouldn’t sigh too loudly just yet. It is reasonable to believe that some of these impacts are indeed temporary. For example, Bloomberg reports the Bank of Japan see good progress toward normalizing production conditions:
“Japan’s economic activity is picking up with an easing of the supply-side constraints caused by the earthquake disaster,” the central bank said in a statement. Increasing output has resulted in an “upturn” in exports, and household and business sentiment has improved, it said.
Toyota and Honda said last month they plan to add thousands of workers in Japan as they increase production. Toyota, the world’s largest automaker, said domestic plants were running at 90 percent of planned levels in June, up from 50 percent in April and May, when output was depressed by a shortage of parts from suppliers.
That said, as Bernanke earlier explained, temporary factors are not all that are in play:
Nonetheless, most participants judged that the pace of the economic recovery was likely to be somewhat slower over coming quarters than they had projected in April.
Why the downgrade? The list is long:
This judgment reflected the persistent weakness in the housing market, the ongoing efforts by some households to reduce debt burdens, the recent sluggish growth of income and consumption, the fiscal contraction at all levels of government, and the effects of uncertainty regarding the economic outlook and future tax and regulatory policies on the willingness of firms to hire and invest.
As if this is not enough, the risks are all downside risks:
Moreover, the recovery remained subject to some downside risks, such as the possibility of a more extended period of weak activity and declining prices in the housing sector, the chance of a larger-than-expected near-term fiscal tightening, and potential financial and economic spillovers if the situation in peripheral Europe were to deteriorate further.
Lions and tigers and bears, oh my. Then comes the disappointing jobs numbers:
Meeting participants generally noted that the most recent data on employment had been disappointing, and new claims for unemployment insurance remained elevated. The recent deterioration in labor market conditions was a particular concern for FOMC participants because the prospects for job growth were seen as an important source of uncertainty in the economic outlook, particularly in the outlook for consumer spending.
Note that this was before the most recent employment report. The situation has only deteriorated further. Indeed, the sharp downturn in employment growth is something of a mystery if the primary factors weighing on the economy, primarily the Japanese tsunami, are widely believed to be only temporary. Firms should be willing and able to look through such disruptions. Simply a heightened sense of caution as the memory of the recession still lingers? Or are the back-to-back weak employment reports indicating a more permanent downward shock to growth, perhaps a cascading effect from the commodity price shock that will not be easily relieved unless the shock reverses itself.
Additional risks to the outlook were seen in the European debt crisis and the possibility the US debt ceiling may not be raised (I sure hope Calculated Risk is correct on this one). Given the general downbeat tenor of the discussion, it is tough to see how they did not open the door further for additional easing. Why not? Policy is held hostage to inflation fears:
Most participants expected that much of the rise in headline inflation this year would prove transitory and that inflation over the medium term would be subdued as long as commodity prices did not continue to rise rapidly and longer-term inflation expectations remained stable. Nevertheless, a number of participants judged the risks to the outlook for inflation as tilted to the upside. Moreover, a few participants saw a continuation of the current stance of monetary policy as posing some upside risk to inflation expectations and actual inflation over time.
On the other side were those that argued there were no indications inflation expectations were becoming unanchored, nor would this be likely when labor costs were subdued. Then comes the paragraph that truly reveals the divergence within the FOMC:
Participants also discussed the medium-term outlook for monetary policy. Some participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate and if inflation returned to relatively low levels after the effects of recent transitory shocks dissipated, it would be appropriate to provide additional monetary policy accommodation. Others, however, saw the recent configuration of slower growth and higher inflation as suggesting that there might be less slack in labor and product markets than had been thought. Several participants observed that the necessity of reallocating labor across sectors as the recovery proceeds, as well as the loss of skills caused by high levels of long-term unemployment and permanent separations, may have temporarily reduced the economy's level of potential output. In that case, the withdrawal of monetary accommodation may need to begin sooner than currently anticipated in financial markets. A few participants expressed uncertainty about the efficacy of monetary policy in current circumstances but disagreed on the implications for future policy.
The group suggesting the need for additional stimulus appears to be relatively small. A more significant group looks at recent data and concludes we overestimated the amount of slack in the system (despite meager wage gains). An apparently nontrivial contingent sees structural issues driving potential output lower, even if only temporarily. And then there are those that are not confident that policy has much impact at this juncture – which implies either do nothing or the next thing they do has to be really, really big. And I doubt there is much support on the FOMC for something really big.
And note that although the group open to additional stimulus caught the attention of the press, it appears they too would wait until it becomes clear that both labor markets remain weak and inflation returns to low levels. I would add that Bernanke raised the stakes further – inflation expectations need to threaten to become unanchored on the downside, a real fear of deflation like last fall. He seems to believe that additional policy would be ineffectual at boosting growth further, and should be reserved for moderating financial disruptions and maintaining inflation expectations. It should be interesting if today he reiterates his point that in the absence of deflation, the tradeoffs of additional policy are not very attractive. If he recants this view, it would signal that he is moving toward additional policy sooner than later. I don't expect such a change.
So what’s the bottom line here? On one hand, the “watch and wait” mode could be viewed as understandable given the multitude of temporary factors in play. That said, temporary factors aside, the overall tenor of the meetings appears to have been very depressing. There is a clear sense the economy is firing on only a handful of cylinders, yet FOMC members cannot completely explain why. And perhaps more importantly, it appears members are operating without consistent theoretical or empirical frameworks. They all seem to be looking at the same set of data through very different lenses. There is no agreement that policy has been effective or ineffective. There is no agreement if inflation risks are high or low. There is no agreement if structural impediments are real or imagined. Given the lack of agreement, it is difficult to see how policy does anything but remain in a holding pattern until a clearer picture emerges. Good news for those worried the Fed would soon tighten. Ongoing weak job reports practically guarantees the Fed will not step on the breaks. Bad news for those looking for more. Until the inflation fears shift back to deflation fears, there looks to remain strong resistance to additional asset purchases.
