Excerpted with permission from the publisher, John Wiley & Sons, from The Little Book of Economics by Greg Ip. Copyright © 2010 by Greg Ip.
Inside the FOMC Meeting
By Greg Ip
For all their market-moving potential, meetings of the FOMC are staid affairs generally bereft of drama. Eight times a year, the 19 members of the FOMC gather in Washington for a one- or two-day meeting. The Fed chairman sits at the center of the table, the other 18 members (assuming there are no vacancies) sit on either side, their nameplates riveted on the back of their seat. The meeting usually begins with a briefing on the financial market developments, which is delivered by the head of markets at the New York Fed.
Federal Reserve Chairman Ben Bernanke
Then, the staff presents the Greenbook, which is its forecast of the economy, and then the reserve bank presidents take turns reviewing conditions in their districts. Next, the staff's director of monetary affairs, also called the FOMC secretary, presents the Bluebook, a list of policy options members could take that day. (A summary is circulated in advance of the meeting.)
After these presentations, all FOMC members discuss their view of the national economy and what they think the Fed should do. Finally, the chairman makes a recommendation and calls a vote. After the meeting wraps up, members help themselves to a buffet lunch. At 2:15 PM, the committee issues its statement.
FOMC members can be classified as hawks or doves. Hawks generally prefer tighter policy than their peers, are more vocal, and are more likely to cast a dissenting vote. Why are hawks so much more outspoken than doves? It's a matter of professional pride. A central banker would rather be known for his toughness on inflation than his concern for unemployment.
"Only hawks get to go to central banker heaven," Robert McTeer, a Dallas Fed president, once said. Doves are more likely to worry about unemployment, and to think that inflation worries are overdone. A central banker with dovish tendencies is like a wine critic who drinks Merlot out of a box. Nothing wrong with it, but best kept behind closed doors.
An FOMC member who is one of the 12 reserve bank presidents (other than New York's) is more likely to dissent than one of the governors. That's because governors share offices, staff, and a sense of solidarity with the chairman. Still, unlike in the Supreme Court, close FOMC votes are unheard of. Inflation and unemployment can animate economics geeks for hours but are much less divisive than the things the Supreme Court grapples with like abortion, freedom of speech, and the rights of suspected terrorists.
The Fed traditionally prefers consensus so the chairman, unlike the Chief Justice of the Supreme Court, carries the day by default. More than two dissents is rare; four in the same direction would be a revolt. Laurence Meyer, a former governor, once joked that there are two red chairs at the table. Only members in red chairs get to dissent.
Punch Bowls and Ham Sandwiches
William McChesney Martin, a former Fed chairman, famously described the Fed's role as taking away the punch bowl just when the party gets going. FOMC deliberations are consumed by figuring out just how much punch to supply. If everyone is having a good time spending money, the Fed cools things down by taking the punch bowl away, that is, by raising interest rates. The opposite is also true: If spending is moribund, it is the Fed's job to supply as much punch as necessary to get the people to come to party in the first place.
Calibrating the punch supply involves several delicate judgments:
How far is the economy operating from its productive capacity, which is its potential output? In other words, how big is the output gap? A related question is how far is unemployment from its natural rate?
How far is inflation from the Fed's preferred level?
What's the outlook for these two things given the forecast for growth, unemployment, and the public's expectations of inflation?
As I described in Chapter Five, both potential growth and the natural rate of unemployment are rather hard to nail down. And any Fed chairman who wanted to keep his job would think twice before asserting publicly that any specific level of unemployment was acceptable or natural.
Fortunately, the Fed makes it possible for a careful reader to discern its estimates of both potential growth and the natural rate of unemployment. Four times a year, the Fed publishes the collective forecasts of FOMC members for major economic indicators. Their long-run forecast of growth roughly corresponds to their estimate of potentialgrowth (around 2.5 percent) while their long-run forecast of unemployment corresponds to their estimate of the natural rate of unemployment (around 5 percent).
What's the Fed's preferred inflation level? Some central banks make it easy to figure this out by publishing a numerical inflation target, usually 2 percent (or a range around 2 percent). The Fed doesn't have a target, but FOMC members' longer-run forecast of inflation serves the same purpose. That range has lately been 1.7 to 2 percent. So if inflation is more than 2 percent or headed over 2 percent, they may want the economy to operate below potential for awhile to nudge it down. If inflation is much below 1.7 percent, they'd welcome a few years of above-potential growth to get it back up.
One thing the Fed doesn't dwell on is the money supply; in the view of its leadership and its staff, it is not much use for predicting inflation or economic growth. The Fed did explicitly target the money supply from 1979 to 1982. Currently, though, entire meetings regularly transpire with no mention of the money supply-- despite that sign in the barber shop.
The growth, unemployment, and inflation picture helps the FOMC decide where to set interest rates. Generally, the further below its capacity the economy is operating, the lower it will keep interest rates in an effort to get it back up. The higher inflation is relative to its preferred level, the higher it will keep interest rates. The Fed's job sounds simple, right? Estimate the output gap, check on inflation, set interest rates, go golfing. May as well replace the Fed with a ham sandwich.
It's harder than it sounds. Monetary policy works with long and variable lags because loan, wage, and price contracts take a while to change. Nothing the Fed does today will affect unemployment or inflation in the next few months. The quarterback throws to where the receiver will be when the ball arrives, not where he is when the ball is thrown.
Similarly, the Fed aims its actions at where the economy and inflation are headed over the next one to three years. If inflation is 2 percent today but the economy is straining its capacity, the Fed needs to raise rates now to keep inflation from rising next year. If inflation is 3 percent but a recession has sent unemployment up sharply, it can cut interest rates, expecting the output gap to get inflation down. If inflation is close to zero then it will keep rates low until the economy is booming so strongly that inflation rises.
All these decisions are prone to error. Potential is unknowable, the future is a guess, and the past isn't much easier given frequent data revisions. People are unpredictable: If rates rise, they may buy fewer homes, or they may buy more if they think even higher rates are on the way.
Since the Fed can never get things exactly right, it must constantly weigh whether it wants to err on the side of being too tight or too easy. For example, as Chapter Five shows, it's easier (though by no means fun) to correct an error that leads to inflation than one that leads to deflation. On a winding mountain road, it is better to scrape your fender on the side of the mountain than to drive through the guardrail and into the canyon.