Pre-FOMC: Trying to look decisive when there are no decisions to make

Some people have been weighing in with some interesting commentary prior to the FOMC meeting on Tuesday/Wednesday. John Taylor thinks that the Fed's dual mandate is a bad idea, and that the Fed should focus only on price stability. Of course, this is standard practice for the ECB, and for central banks with explicit inflation targets, e.g. the Bank of Canada, the Reserve Bank of Australia, the Bank of England, and the Reserve Bank of New Zealand. Taylor cites a paper by Dan Thornton (St. Louis Fed), who looks at the language in Fed policy statements, and finds a recent inclination of the Fed to get much more specific about the second part of the dual mandate. For example, the last FOMC statement says:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.

This is much stronger than the vague pre-financial crisis language about "sustainable economic growth," for example.

This trend, and public statements like those of Charles Evans, Chicago Fed President, have Paul Volcker worried. The key part of Volcker's NYT op-ed is this:

My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate.

Volcker, as you remember, was the Fed Chairman faced with the task of eliminating the inflation caused by the well-intentioned Fed officials of the 1970s - the Ben Bernankes and Charles Evans of their day. Thus, his opinion should carry some weight, though Paul Krugman of course does not think so.

This WSJ piece suggests that Charles Evans and Charles Plosser (Philadelphia Fed President) have been assigned the task of working out explicit dual mandate targets, as envisioned by Evans. Of course, this leans further in a bad direction. It seems particularly dangerous to be making explicit statements about targets for the unemployment rate, for example. The Fed certainly has no control over the unemployment rate in the long run, and how much influence it can have even over short periods at the best of times is debatable. Further, right now there is absolutely nothing further the Fed can do to move the unemployment rate down.

Essentially, the Fed is faced with a non-decision. Under the current circumstances, with a large positive stock of reserves, all that can matter is a change in the interest rate on reserves (IROR). The Fed will not likely move the IROR to zero, for technical reasons that have to do with money market mutual funds. It will not move the IROR up, as it is not ready to tighten yet. It has already committed to to keeping the IROR at 0.25% for close to two years in the future, and extending that period is not only unlikely, but foolish (as indeed was the commitment made at the last meeting).

What will the Fed do? I think it unlikely that they will actually buy more long-maturity Treasury bonds - i.e. embark on QE3. The most likely outcome will be to lengthen the average maturity of assets in the Fed's portfolio through swaps of short-maturity for long-maturity Treasuries. This of course will accomplish absolutely nothing. However, I think most of the FOMC is convinced that it will.