Today, the Federal Reserve released the minutes of January's Federal Open Market Committee meeting. When analyzing the statement a few weeks ago, I noted my surprise at Kansas City Fed Governor Thomas Hoenig's decision to vote against the monetary policy action. While I generally find myself on the same page as Hoenig, I didn't agree with his vote. But today's minutes provide some additional detail, so let's look at why he actually dissented.
The Fed minutes say:
Mr. Hoenig dissented because he believed it was no longer advisable to indicate that economic and financial conditions were likely to "warrant exceptionally low levels of the federal funds rate for an extended period." In recent months, economic and financial conditions improved steadily, and Mr. Hoenig was concerned that, under these improving conditions, maintaining short-term interest rates near zero for an extended period of time would lay the groundwork for future financial imbalances and risk an increase in inflation expectations. Accordingly, Mr. Hoenig believed that it would be more appropriate for the Committee to express an expectation that the federal funds rate would be low for some time--rather than exceptionally low for an extended period. Such a change in communication would provide the Committee flexibility to begin raising rates modestly. He further believed that moving to a modestly higher federal funds rate soon would lower the risks of longer-run imbalances and an increase in long-run inflation expectations, while continuing to provide needed support to the economic recovery.
Hoenig's concern is understandable. As I've mentioned before, whether we like it or not (I don't), the market overanalyzes the Fed's every word. While nobody really knows what "an extended period" means, it probably doesn't mean a month or two. Hoenig must prefer "some time" because it's a tad more vague, which means it gives the Fed a little more wiggle room to raise rates sooner if necessary. He must anticipate that could happen if the recovery suddenly becomes more rapid.
I don't entirely disagree with Hoenig -- insofar as it would be nice for the Fed to feel less pressured to keep rates very low, in the unlikely event that a broad, robust recovery is suddenly sprung upon us. Yet, as I just mentioned, the market looks at the Fed statement probably too closely. So it would definitely notice if the language changed from "an extended period" to "some time." And there's a danger that it could freak out.
Presumably, that's what the other committee members worried about. While most economists believe that we're in a recovery, they also see that recovery as slow, particularly for employment. As a result, the economy is still fragile. The last thing the Fed should do is something that might spook the market. That could send banks and investors reeling and help cause a double-dip recession.
But don't get me wrong: the Fed can't avoid raising rates forever, so it can't say that they should be kept low for "an extended period" forever either. Should it change that language during the March meeting? What about April or June? It depends on the recovery. If employment shows tangible improvement, consumer sentiment and spending continue on an upward trend, the housing market clearly stabilizes and the financial markets are successfully weaned off government and Federal Reserve assistance, then perhaps. So until we can be sure that the recovery won't regress, I'll have to side with the majority of Fed governors on this one.