Bernanke vs. the Borg: A Short History of the Fed's Amazing Transformation

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Kocherlakota's evolution shows Chairman Bernanke hasn't forgotten Professor Bernanke

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(Youtube/Minneapolis Fed)

Central bankers -- they're just like us! Sometimes they make mistakes. Less often, they admit those mistakes. And even less often than that, they change their minds. That's what makes Minneapolis Fed president Narayana Kocherlakota so refreshing -- he's been open to evidence, and willing to disregard his past positions.

Kocherlakota is a self-styled inflation hawk. You pretty much have to be if you want to be a central banker -- outside of, say, Zimbabwe circa 2005-09. But more than most at the Fed, Kocherlakota has worried that unconventional monetary policies will only increase inflation without increasing employment. He's been concerned our labor market problems are structural. In other words, that companies can't find the right people for their job openings, and the unemployed can't find companies that have the right job openings for them. This kind of mismatch, if it existed, would be another unhappy consequence of the housing bust. The idea is the unemployed don't have the right skills or live in the right places to find a job -- the former because they worked in a bubble industry like construction; the latter because they lived in a bubble area that's left them underwater and unable to move. Printing money would do nothing for these problems, but it might do something for inflation. It's an intuitively appealing story. Except for the evidence bit.

Economists have looked far and wide for any hint of mismatch. They haven't found much. As Mike Konczal of the Roosevelt Institute notes, unemployment has shot up across both high and low-skill occupations -- the opposite of what the structural story says should happen. Then there's the lack of labor shortages. If our unemployment problem is really a problem of not enough skilled labor, we would expect wages for skilled labor to jump. That hasn't happened, as Paul Krugman points out. You know what else hasn't been rising -- at least not very much? Prices. Core inflation has stayed subdued -- again, the opposite of what the structural story says should happen.

But this inconvenient lack of facts didn't stop Kocherlakota. He was a man on a mission to find a reason to tighten policy -- and the less proof there was, the less coherent he became. In 2010, Kocherlakota warned the Fed had to be careful about its low-interest-rate policy because it "must lead" to deflation. Yes, deflation. Economist Andy Harless compares this to saying umbrellas cause rain. It gets the causation completely backwards. The Fed lowers rates when inflation is low, but lowering rates doesn't lower inflation. The opposite. Imagine if Ben Bernanke promised to never raise interest rates, ever. (Leave aside the question of how credible this promise would be). Inflation of the "hyper" variety would very quickly set in.

Kocherlakota's reasoning changed a year later, but his conclusions did not. In August 2011, he dissented from the Fed's forward guidance that it expected economic conditions to warrant near zero rates through mid-2013, because ... inflation?


If you're wondering how Kocherlakota could worry about inflation when he had said low rates cause deflation, well, don't. It's not worth it. What is worth it is a reminder about what happened to the labor market when Kocherlakota said it had improved. The chart below looks at the employment-population ratio, which shows us what percent of working-age adults are in fact working. See the recovery? Try squinting.
EPop5.png

I don't mean to pick on Kocherlakota. At least he was making evidence-based arguments, even if they weren't particularly good evidence-based arguments. That's more than could be said of the other so-called inflation hawks. And it's why Kocherlakota eventually broke with them.

What if I told you Kocherlakota had come up with one of the more aggressive plans for the Fed to fight unemployment. You'd probably say that sounds like the plot of one of those awful body-switching movies. (It's Freaky Friday meets the Federal Reserve!). Well, it's not. Kocherlakota not only said he would have voted for QE3 -- he does not have an FOMC vote this year -- but also outlined his own version of colleague Charlie Evans' plan to jumpstart the recovery. Kocherlakota wants the Fed to promise to keep rates near zero until either unemployment is below 5.5 percent or inflation is above 2.25 percent. The idea is that promising to keep rates low even after the recovery has picked up -- and explicitly defining what that means -- will get people to spend more now without getting much more inflation, as M.I.T. economist Ivan Werning has argued.

Why did Kocherlakota change his mind? Well, he didn't -- at least not entirely. If unemployment really is structural, then inflation will go up long before unemployment goes down to 5.5 percent. Kocherlakota is admitting he might have been wrong, and proposing a way to test if he was. It's not quite the radical break it seems at first, but it's a significant break nonetheless. That still leaves the question of what made him think he might be wrong. The answer: lots of emails from Ben Bernanke. Here's what Fed whisperer Jon Hilsenrath of the Wall Street Journal tells us about Kocherlakota's evolution.

"I've learned a lot by talking to [Bernanke]," Mr. Kocherlakota said in an interview after the September meeting. Mr. Bernanke's "thinking is framed by data and models," he said. "It beats coming in there with just your gut."

I know what you're thinking -- there are people at the Fed who just go by their guts? Yes. Dallas Fed President and perpetual inflation hawk Richard Fisher said he opposed QE2 because "his gut" told him that it would "result in some unpleasant general price inflation." It didn't. Remember, Fisher even opposed cutting interest rates to zero in December 2008 -- when the financial apocalypse was upon us -- before Bernanke apparently brow-beat him into reversing himself.

Central banking isn't really about interest rates. It's about making and keeping promises. That's why central bankers worry so much about their "credibility", and why Bernanke was so slow to start QE3. When short-term interest rates are stuck at zero, central banks have to promise to keep policy easy in the future to get the economy moving again -- what Paul Krugman called a "credible promise to be irresponsible" in his 1998 paper on Japan. But there's the small challenge of making promises about the future when you might not be around in the future. Like Bernanke. His term is up in 2014, but QE3 makes promises beyond that. Markets might not believe the Fed's promises today if they think those promises will change if the Fed's leadership changes. In other words, Bernanke didn't want to do QE3 until he had persuaded all of the persuadable members of the Fed to support it. Like Kocherlakota.

This answers the big psychodrama surrounding the Fed -- what does Ben Bernanke think of Ben Bernanke? In other words, why wasn't Bernanke following the advice he gave the Bank of Japan to be much more aggressive amidst a depressed economy? Had he been assimilated into the "Fed borg", as Paul Krugman worried? No. It turns out Chairman Bernanke remembers Professor Bernanke plenty well. He was just making sure his colleagues did too.
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Matthew O'Brien

Matthew O'Brien is a former senior associate editor at The Atlantic.

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