Federal Reserve Fretting About Inflation in 2008: Monday Focus: February 24, 2014

Paul Krugman puts this in the proper context:

Paul Krugman: The Urge To Tighten: “People are going through the Fed’s 2008 transcripts, and finding that most officials had no idea what was going down… really surprising… dismaying… a number of Fed officials were… focused on inflation… eager to raise rates…. A fair number… very much not, however, including Janet Yellen… would, if they could, have echoed the ECB’s big mistake. What’s… shocking… is that official Fed doctrine is to focus on core inflation… headline inflation has swung widely, while focusing on core inflation has been a much better (though not perfect) guide to appropriate policy. Were Fed officials just not on board with this doctrine?

But things are actually much stronger than Paul says: in the three decades since the start of the late lamented “Great Moderation”, of the 15 substantial divergences between core and headline inflation, core inflation is a better guide to what headline inflation will be in two years in 13 of the 15–and core inflation is a better guide to what core inflation will be in 2 years, and hence what headline inflation will be in 4, in 14 of the 15.

So we are surprised when somebody like Richard Fisher, President of the Dallas Fed, says things like: “whatever inflationary pressures were building up toward the end of the summer – and they were significant…” Did nobody on his staff teach him about the difference between core and headline inflation–and the superior reliability of core? Did the teaching just not take?

The distinction between core and headline inflation was a genuine and important macroeconomic insight, developed by Robert J. Gordon in 1975: Robert J. Gordon, (1975), <a href="http://www.brookings.edu/~/media/Projects/BPEA/1975%201/1975abpeagordon.PDF”>”Alternative Responses of Policy to External Supply Shocks”, Brookings Papers on Economic Activity 1975:1 (Spring), pp. 183–206. Yet it has apparently dropped out of at least one of the wings of macroeconomics–Chris House, for example, makes no reference to core inflation in his defense of Federal Reserve inflation hawks in 2008:

Chris House: The Fed in 2008: “There were people who were concerned about inflation.

This seems odd given what we know followed (and odd given that a bit more inflation would be welcome news today) but, at least to a small extent, it was part of the data at the time. Some commodity prices, and oil in particular, were both rising which seemed odd given what policy makers were hearing from lenders. Jim Bullard has an interesting recent presentation on this in which it seems like he is arguing that oil supply shocks may have shaped the Fed’s assessment of the problem that summer…

It is a mistake to take moves in headline inflation that are deviations of core inflation as signals of anything.

And it is only by looking at what we got wrong in the past that we can mark-our-beliefs-to-market and do better in the future. So we are even more alarmed when people like Fisher demand that people not engage in Monday-morning quarterbacking of 2008. How can you mark your beliefs to market if you do not compare what you thought to what was true?

Yet a great many FOMC meeting participants appear to have been unaware of the distinction between core and headline inflation in 2008:

Binyamin Applebaum: Fed Misread Crisis in 2008, Records Show: “The outlook of Fed officials also reflected a deeply ingrained bias to worry more about the risk of inflation than the reality of rising unemployment.

As Fed officials gathered on Sept. 16 [2008] at their marble headquarters in Washington for a previously scheduled meeting, stock markets were in free fall. Housing prices had been collapsing for two years, and unemployment was climbing. Yet most officials did not see clear evidence of a broad crisis. They expected the economy to grow slowly in 2008 and then more quickly in 2009. The transcript for that meeting contains 129 mentions of “inflation” and five of “recession.” Mr. Bernanke even told his colleagues that it was clear the economy had entered a downturn but that he still did not favor cutting rates. “I think that our policy is looking actually pretty good,” he said.

That optimism would not long endure. Just minutes after the end of that first meeting, a smaller group of Fed officials agreed to rescue the faltering insurance giant the American International Group, a company never before subject to Fed supervision that until then was barely on the government’s radar…

And:

Shahien Nasiripour and Zach Carter: Federal Reserve Transcripts Show Fretting About Inflation As Economy Collapsed: “Top Federal Reserve officials were haunted by an imaginary inflation epidemic during eight months preceding the cataclysmic 2008 Lehman Brothers bankruptcy….

In a sign of Fed officials’ priorities, the word “inflation” appears more than 1,500 times in transcripts of the central bank’s Federal Open Market Committee meetings in 2008. But in those months preceding Lehman’s collapse, the word “crisis” garners about 50 mentions. Some of the more vocal… participants, such as James Bullard… argued in 2008’s pre-September months there was little, if not “zero,” systemic risk in the financial system. Others, such as Harvey Rosenblum, a top official at the Dallas Fed, worried about the damage to the Fed’s reputation if it was found that the Fed had helped financial institutions, on preferential terms….

“I think it would be wise … to take a newspaper across the snout and call for a 25 basis point increase,” Richard Fisher, president of the Dallas Fed, said that August [2008] in calling for the Fed to raise its main interest rate by 0.25 percent:

We’re always talking about tightening at some point. I think it just becomes increasingly difficult to take that first step. I grant you that the economy is weak. The financial situation is brittle. That hasn’t changed in my view, but the inflationary behavioral patterns that I’m beginning to hear about reinforce my concern[s].

At the time, Fed officials outside Washington and New York reported hearing from contacts in the business community that prices were rising, inflation was looming, and the Fed’s credibility to maintain stable prices may be in question. In one notable exchange, after Fisher ticked off a list of “chilling anecdotes” about coming inflation, Bernanke asked him what he said was a “very innocent question”:

Official statistics just don’t show anything like that outside of oil, gas, gasoline, and the direct commodity price increases. Do you believe that the [government’s consumer price index] is not an accurate measure?”

Fisher responded that what he heard was consistent with the data, but that he was “just trying to report what I’m hearing from the field.”…

In August 2008, in response to statements by other Fed officials that the Fed was unjustified in its attempt to prop up the economy, Yellen said:

We are likely seeing only the start of what will be a series of bank failures that could make matters much worse. Given these financial headwinds, it is not clear to me that we are accommodative at all….

Yellen stood out by noting that the central bank was doing a lousy job with the companies it already had authority over:

What is going on raises fundamental issues about how we conduct consolidated supervision. I am not at all convinced that the way we are carrying out supervision now would have prevented a Bear Stearns-type of episode within an institution that is currently solidly under our supervision….

Citing a 2005 paper by economist Raghuram Rajan, who has since become India’s top central banker, in which he noted the misaligned incentives between managers of financial institutions and investors, Yellen said:

I don’t know what they were thinking, but everybody was rewarded for the quantity and not the quality of [mortgage] originations. He warned us before any of this happened that this could come to no good, and I think he did have some suggestions about compensation practices. These were not popular suggestions. I think this is worth some thought. “I don’t know what the answer is in terms of changing these practices. Maybe the market will attend to them, but it seems to me that we have had an awful lot of booms and busts in which this type of incentive played a role….

Geithner appeared in the early months of 2008 to be among the most optimistic Fed officials when assessing the overall strength of the financial system…

And:

Jon Hilsenrath: A look inside the Fed as financial crisis unfolded: “Officials acted boldly in January 2008, but spent much of the northern spring and summer hamstrung by uncertainty, disagreement and an unexpected inflation jump….

Ms Yellen, who became Fed chair on February 1, emerges in the transcripts as a loyal ally of Mr Bernanke. She was often presciently worried about unfolding developments, and among the first to call a recession, but in some instances she was wrong about how the crisis would play out and in others unprepared to push Mr Bernanke any further than he was ready to go….

In June, Mr Bernanke gently chastised Mr Fisher for voting against a decision to keep interest rates steady in the face of rising inflation. The Fed acknowledged in its statement it was alert to inflation risks, as Mr Fisher wanted, but he also wanted a rate hike. “I’m disappointed that president Fisher is going to vote against his own language,” Mr Bernanke said….

In July, as the financial system teetered, officials looked on as the consumer price index shot up to 5.5 per cent from a year earlier.

At the September 16 meeting, the Fed again decided to keep its short-term interest rate steady at 2 per cent. Mr Bernanke said the Fed didn’t have enough information at that point about the fallout from Lehman’s collapse to justify cutting interest rates. “It is simply premature,” he said. Ms Yellen went along with Mr Bernanke’s decision at the September meeting to keep rates steady, but she warned: “I am very concerned about downside risks to the real economy and think that inflation risk is diminished.”…

By year-end the Fed had cut interest rates to near zero, announced plans to start buying government-backed mortgage-backed securities, and set up programs to prop up money-market funds and individual banks such as Citigroup…