Wednesday, August 6, 2008

They may rule...but what's a dove?

Unity in separatism - The Fed is classically looked up as an organization that is mostly close-knit but where members regularly clash over the outlook and policy, but in the nicest of ways. The Fed is well-known for its collegial atmosphere. Members have and maintain separate views and even encourage such differences in opinion to get the analysis of the economy right.

Hawks and Doves: While many different camps or splinter groups can be identified is trying to assemble the FOMC members into ideological groups, the most stark division is the partition of the FOMC between Hawks and Doves.

  • Hawks are the ardent anti-inflationists who usually see inflation risks where others do not. They are more likely to be voting for rate hikes or to slow down rate cuts.
  • Doves typically are more pro-growth and are more concerned that policy might be holding the economy back from its best growth potential. Doves are more likely to be voting for rate cuts or against the rate hikes, that they view as unneeded.

Hawks VS Doves: not a full partitioning -- Even though at any particular meeting we can usually put members into a rate cutting or rate hiking camp that does not mean that all members of a group seek that same policy for for the same reason. Indeed after different times you may see the same member in different groups since policy is often a judgment issue not simply about dogma.

Naming some names... Three names appear in guise of hawks although only one dissented at this past Fed meeting.
  • In this cycle we can identify Dallas Fed president Richard Fisher as a super, but conditional, hawk. I name him as such because he can be depended on repeatedly to vote against a policy to stand pat with rates preferring a hike. He was against the last Fed rate cut and continues to protest that cut with his dissent. But if the Fed were to retract that cut and hike rates would Fisher continue to want rates higher still? We don't know.
  • Charles Plosser is a former member of the SOMC (Shadow Open Market Committee) and a very well know anti-inflationist. Ahead of the August 2008 meeting he had been saying that rates would have to go up 'sooner rather than later'. Still he did not dissent in August.
  • Neither did Minneapolis Fed President Gary Stern dissent. He had sounded somewhat hawkish ahead of the meeting. He voted with the majority to stand pat and on little change in the policy language.

So who were the doves that carried the day? What did they believe?

The doves are not classical doves and the hawks are different too -- The classical dove definition does not seem to apply here. Few on the Fed- IF ANY AT ALL - seek rate cuts. What we have instead are hawks with real inflation fear as oil prices shot up near $150/bbl and as the CPI headline neared 5% tempering their traditionally expected actions. In this environment doves are more concerned with financial stability than with growth or inflation. Hawks have come to realize that the trade offs are not just inflation or growth but also financial stability- that has changed the game and the debate at the Fed.

  • This makes the current Fed Hawk/Dove dilemma richer and more vexing to understand.
  • In this environment Hawks are not simply trying to stop inflation at the cost of some near term growth. But they have to balance the risk of inflation against the possibility that too aggressive an anti-inflation posture might be even more dangerous to the economy.

Financial instability is the risk of this period not simply recession. It portends a loss that could be much more damaging. Hawks know that inflation left unchecked will cause great problems and will lead to even more rate hiking later on and, eventually a worse recession. Anti-inflation hawks aim to head off such consequence. Doves typically don't disagree with them about consequences, but about the degree of the risk in the current circumstance. For the first time the hawks have to balance the risks of inflation with the risk of financial backsliding. So the argument of the doves is more subtle and more powerful than it used to be. Financial backsliding is a much more vexing worry.

The Fed knows that recessions come and go. This is what makes the hawks willing to risk recessions. Recession is worth the price if it stops inflation and avoids a bigger recession later on. But when the risk is not just a 'garden variety' recession but something potentially more lasting and devastating it changes the decision process.

That is how headline inflation got to be so high. It was the realization that to counteract it would have taken a rate hiking policy at a time the Fed in fact chose to cut rates. There were in fact no dissenters at that time to that course of action. Still, core inflation has emerged from this episode relatively well behaved. The Fed's credibility is still in tact. The Hawks and Doves are still engaged in conflict, but is a new one. The costs are not as clearly specified and that makes both sides more careful.