This note is arguably a bit self-indulgent. It was inspired by a client who sent me Mike Feroli’s take on Warsh’s first Press Conference. Feroli was his usual polite and understated self. Let me be his anger translator.
I have been writing a bit recently about how Fed Chair Warsh has mischaracterized the role of the balance sheet in monetary policy. The main practical points are that a smaller balance sheet will not create space for lower interest rates and that there is no sense in which a larger balance sheet enables fiscal expansion. At his inaugural Press Conference Warsh seemed to drop his earlier claims, which I would say is an advance.
But his performance following the last FOMC meeting was not entirely innocent. For example, he brutally mischaracterized the role of the Phillips Curve in the Fed’s conduct of monetary policy. Here is his reaction to a follow-up question from CNBC’s Steve Liesman about whether (relatively) strong employment growth, among other things, might be an indication that policy is not restrictive:
I’ll just make one other point. You talked about one of our dual mandates and the employment side. I don’t believe that we have a cruel choice. I don’t share the view that was expressed a few generations ago that Federal Reserve chairmen show up a podium like this and say, “You’ve got to choose. And you’re going to have to decide whether you’re willing to tolerate higher inflation to put more people at work.” I don’t believe in that. What I believe is if we do our job, we can make strong growth, low prices, and strong employment mutually compatible.
Source: P.15 here.
There are two points about this claim that are striking in a bad way. And I will take them in increasing order of importance. First, whether the Phillips Curve is valid or not is an interesting and live debate, but the correct answer to that debate is entirely independent of the character of those involved in it. Or to put it more simply, it does not matter if the Phillips Curve is cruel or kind. All that matters is whether it is correct and in what form. I have been watching the Fed since Greenspan and I can report with some confidence that this muddying of the normative with the positive is new – and not in a good way. (Regrettably, Greenspan often posed as the nation’s chief political philosopher, but he kept that out of his analysis.)
Second and more fundamentally, the idea that the Phillips Curve was taken seriously only “generations” (multiples of 20-year periods) ago is absurd, as is the suggestion that adherence to it implies that the Fed believes that there is a durable trade-off between employment and inflation. Presumably Chair Warsh has read the most recent update of the Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy, which has now been kicking around in roughly unaltered form for 14 years. It makes crystal clear that the level of employment over time is determined by structural forces that are largely outside the control of the Fed, which contrasts sharply with the pace of inflation which the Statement treats as a choice by the Fed.
Faith in the Phillips Curve, for good or ill, involves the belief that that excessive aggregate demand will show up first in an overshoot of employment relative to its natural level, determined by those structural forces, and only later in inflation. It casts the level of employment, relative to natural, as an indicator of inflation pressures, and not as something about which the Fed can make a choice, cruel or otherwise. Is this difficult?
Nor does the logic of the Phillips Curve imply that the natural rate of unemployment is directly observable or knowable with any precision. The logic of the Phillips Curve says that employment moves first in response to the development of excessive demand. And the truth of falsity of that perspective is entirely independent of whether the natural rate can be known in real time. Moreover, the consensus on the Fed respects this fact, which goes a long way to explaining why even Phillips Curve fans on the FOMC have moved in a hawkish direction, even though their best guess of the state of the labor market would not seem to warrant that shift. They have been watching inflation directly – and not getting distracted by the Trimmed Mean, I might add.
Let me conclude with one final thought on the Phillips Curve, which is not really related to what Warsh has been on about. One of the motivations for the development of what we call the New Keynesian Phillips Curve is that academics in the 1970s and early 1980s wanted to rescue the idea that monetary policy has real effects from the rational expectations revolution that seemed to exclude that possibility. I think folks who pride themselves on having common sense and not getting confused by academic mumbo jumbo, such as perhaps Warsh, would agree that monetary policy has real effects. So, I guess my question for these hard checking real world types would be, how?
For now, observers are giving Warsh the benefit of the doubt because he is new to the job and because the consensus is quite understandably that he is not stupid. Even his harshest critics, among whom I would include myself, would concede he is clever and a smooth operator. But he is going to run into trouble if he continues to make stuff up and mischaracterize the views of his colleagues on the FOMC. Let’s see if he can learn. He might also want to stop slagging incontestably the best national statistics service in the world, dealing with questions that are actually difficult, but that is a whole nother story.
