During the 1970s, the doves were consistently wrong, and for the most part denied they were wrong, even after the fact. Inflation (they said) was caused by “non-monetary” factors. Now we all know that was hogwash; NGDP was rising at 11% per year. And non-monetary factors like oil shocks and strong unions have no impact on NGDP.
Since 2008 it’s been the exact opposite, the hawks have been consistently wrong. There is no shame in being wrong, but it is shameful not to admit you were consistently wrong in the past, when the facts clearly suggest you were. Oddly, Benn Steil and Dinah Walker now think it’s again the doves who are at fault.
Do Fed doves and hawks get their aviary classifications based on their cold, hard analysis of data, or is it the reverse – do they select data points to justify their dovish or hawkish perspectives?
The history of the Fed’s post-crisis focus on unemployment suggests the latter. After June of 2013, as the figure above shows, the Fed’s estimate of the natural long-term unemployment rate begins declining in sync with the decline in the actual unemployment rate. This suggests that FOMC members are lowering their estimates of the natural rate of unemployment to justify keeping interest rates at zero longer than they could if they stuck by their initial estimates, the 6% consensus upper bound of which is now above today’s actual 5.9% rate.
We cannot test this hypothesis directly, by checking each member’s estimate history, because the estimates are anonymous. But we can check whether the phenomenon can be explained merely by a change of FOMC composition: it cannot. The distribution of participants’ estimates shows conclusively that some of them have indeed revised their estimates lower. Given that these are supposed to be estimates of the long-term natural unemployment rate, this is more than curious.
With core PCE inflation, the Fed’s preferred inflation measure, running at 1.5%, still comfortably below the Fed’s 2% long-run target, there is little compelling reason to begin hiking rates immediately. But given its upward trajectory from 1.2% at the start of the year, there is surely now reasoned cause for bringing forward the Fed’s old September 2012 calendar-guidance of zero rates through mid-2015 – which the Fed doves are still strongly wedded to.
Our observations suggest that monetary dovishness and hawkishness are often fixed states of mind, rather than artifacts of a consistent approach to data analysis. If so, there is reason to fear that the Fed’s exit from monetary accommodation will be too late and too tepid – with the result being higher future inflation than the market is pricing in right now.
Obviously it’s possible they are right, but it seems extremely unlikely. The doves have good reason to delay their estimate of the optimal time to raise rates; the markets are suggesting that we are not approaching the Fed’s multiple policy targets as quickly as the unemployment numbers would suggest. If 5.4% really was the natural rate of unemployment, then there is no way the 5-year TIPS would be plunging rapidly below 2%, and the 10 year T-bonds would be 2.3%. After all, we will be at 5.4% unemployment in about 5 months. Once we fall below the natural rate, the standard model (i.e. the Fed’s model) says inflation should rise. But there are no signs that inflation will rise. Steil and Walker cite historical data, but market inflation expectations are much better. It’s not a good idea to try to steer the car by looking in the rear view mirror. It’s not wise to second guess market forecasts.
Unfortunately we lack a NGDP futures market, which would have made it much easier for me to make this argument. The government and the economics profession deserve ridicule for the fact that this market does not exist.
I do agree with the first sentence of their final paragraph, and have a new post on that topic over at Econlog. But I draw the opposite conclusion—it’s the hawks we need to fear.