What Would Mishkin Have Done?

I promised myself I wouldn't get sucked into the black hole of the 2008 Fed transcripts, but that has proven an impossible promise to keep. In my previous post, I speculated that Rick Mishkin's departure from the Fed considerably weakened it at a critical time. I also said this was nothing more than an amusing parlour game. That was wrong - amusing, yes, unimportant, no. I don't know Mishkin, though I'm aware his reputation took a bit of a beating thanks to the Inside Job. But when I was trying to learn more about monetary policy four years ago, it struck me that Scott Sumner kept saying, "This isn't unorthodox. You get this from Mishkin's textbook, which is the best-selling book on the subject." So I read Mishkin's book. It is thus of incredible importance and interest what the textbook writer himself was saying as we entered the teeth of the crisis. It's too much trouble to go through all of the transcripts - I'll leave that to Binyamin Applebaum and team - but here are some crucial points from Mishkin's last meeting on Aug 5 2008. Mishkin's actual words from the transcripts are in italics.

1) Focus on core inflation, not headline. Also, anecdotal evidence should really, really be taken with a pinch of salt. This should be obvious to experienced policymakers, but going through the psychological barrier of $100 oil (not to mention $13 natural gas) had clearly rattled some. Richard Fisher was pushing his inside knowledge from CEOs as evidence of inflation expectations becoming untethered. Mishkin responded:

Monetary policy does not control...relative price shifts. Although there are some problems in terms of core, the effect has actually been quite limited given the incredible rise in energy prices. While it’s important to think about headline in the long run, the information from core is very useful in terms of thinking about policy because it tells you whether this is spilling over into underlying inflation. 

I am very skeptical of consumer surveys because, exactly what behavioral economics tells us, there is framing. If headline inflation is high, short-term inflation expectations go up, which should happen, but long-term inflation expectations also go up. When headline goes down, then they will come down. 

One of my concerns about going to anecdotal information and why I think we need to use an analytic framework in thinking about what is really driving the inflation process is that we do need to focus on the longer-run because that’s what monetary policy can control. I get a bit nervous about these anecdotal concerns, which I think can tell us something about headline. Then we have to ask what they tell us about the longer-run context but not put too much weight on them. That’s one reason that I think some of the analytic frameworks that we’ve developed here are very useful for thinking about these things.

I think that this is very important—it is why I stressed the issue of the analytic framework for thinking about the inflation process and what monetary policy can do. We can’t control relative prices, but we can do something about long-run inflation expectations and expectations about future output gaps.

I'll note that Mishkin himself was not immune to the importance of oil prices, worrying that it would actually lead to long-term inflation expectations changing:

Let’s hope and pray—let’s all get around in a circle and hold hands—that oil prices fall, which will also help us not get boxed in.

2) Inflation was less of a concern than macro stability.

When you have very big downside risks to economic activity, you want to deal with inflation expectations when they actually indicate that there is some problem. And I just do not see that at this juncture. 

3) The federal funds rate does not indicate the stance of monetary policy. Instead, look to all asset prices.

Let me talk about the issue of focusing too much on the federal funds rate as indicating the stance of monetary policy. This is something that’s very dear to my heart. I have a chapter in my textbook that deals with this whole issue and talks about the very deep mistakes that have been made in monetary policy because of exactly that focus on the short-term interest rate as indicating the stance of monetary policy. In particular, when you think about the stance of monetary policy, you should look at all asset prices, which means look at all interest rates. All asset prices have a very important effect on aggregate demand. Also you should look at credit market conditions because some things are actually not reflected in market prices but are still very important. If you don’t do that, you can make horrendous mistakes. The Great Depression is a classic example of when they made two mistakes in looking at the policy interest rate. One is that they didn’t understand the difference between real and nominal interest rates. That mistake I’m not worried about here. People fully understand that. But it is an example when nominal rates went down, but only on default-free Treasury securities; in fact, they skyrocketed on other ones. The stance of monetary policy was incredibly tight during the Great Depression, and we had a disaster. The Japanese made the same mistake, and I just very much hope that this Committee does not make this mistake because I have to tell you that the situation is scary to me. 

4) The Great Depression and Japan were appropriate parallels to be thinking about in Aug 2008. See the quotes in part (3) as well as the now famous one below:

Remember that in the Great Depression, when—I can’t use the expression because it would be in the transcripts, but you know what I’m thinking—something hit the fan, [laughter] it actually occurred close to a year after the initial negative shock.

So there you have it. Mishkin knew what he was talking about, and I think it's pretty clear that his departure was a loss. Whether he would have been able to influence the entire group is subject to (even more speculative) debate.  But if there's one lesson here, it's that orthodox, textbook monetary policy should and could have prevented 2008 from being as bad as it was. I just hope someone in Europe has a copy of Mishkin's book.