The Fed's January Meeting: What Happened, and Why It Matters

The minutes from January’s meeting of the Open Market Committee (FOMC)—the Federal Reserve’s policy-making body—were released this week and reveal some interesting conversations. Here are a few highlights.

First, the minutes indicate FOMC members are increasingly confident that the economy is heating up and inflation is firming. Consequently, they expect a “gradual upward trajectory of the federal funds rate would be appropriate”. That is, they expect interest rates to be raised higher than at the last FOMC meeting. Expect multiple rate hikes this year.

Second, the minutes reveal a renewed interest among the FOMC as to why inflation has been persistently undershooting the Fed’s own two percent inflation target. Whether one measures inflation using the de jure target—the Personal Consumption Expenditures (PCE) deflator—or the de facto target—the core PCE deflator—it has average near 1.5 percent since the recovery started.  While that may not seem a big miss, these misses add up over time and suggest something is amiss with monetary policy.

The minutes show many FOMC members are wondering why this inflation undershooting his happening. One reason for their confusion is that their theory for inflation does not seem to be working. As the minutes note:

“Almost all participants who commented agreed that a Phillips curve-type of inflation framework remained useful…”

This framework says inflation will rise as the economy’s excess capacity shrinks. With the unemployment rate at 4.1 percent, many FOMC member believe the excess capacity has been squeezed out but where is the inflation?

The failure of the Phillips curve to predict inflation is nothing new. Milton Friedman outlined its shortcomings 50 years ago and its problems are well known. Among its many challenges, the Phillips curve relies on the unmeasurable notion of excess economic capacity, arguably has causality backwards, and ignores the link between money and inflation. Yet, as noted above, many FOMC members continue to use it to inform their decision-making. This amounts to a faith-based belief in the Phillips curve, as noted by Minneapolis Fed President Neel Kashkari.

The minutes reveal that a few Fed officials are wary of the Phillips curve dogma:

“A couple of participants questioned the usefulness of a Phillips curve-type framework for policymaking, citing the limited ability of such frameworks to capture the relationship between economic activity and inflation.”      

This Phillips curve heresy of two may not seem like much, but keep in mind there are currently only eight members on the FOMC.. More importantly, this dissent was part of a broader conversation that all FOMC members are having over the low inflation. The fact this conversation is happening in progress.

Third, the minutes show that FOMC officials are once again debating whether the framework of monetary policy should change. One suggestion was to do an inflation target range:

“A couple of participants suggested that the Committee might consider expressing its objective as a range rather than a point estimate.”

This would be like the Bank of Israel (BoI) which targets one to three percent inflation. Over the business cycle, BoI hopes to average two percent, but the range gives it flexibility both politically and economically. Another suggestion was to move to some form of price level targeting:

“A few other participants suggested that the FOMC could begin to examine whether adopting a monetary policy framework in which the Committee would strive to make up for past deviations of inflation from target…”  

This would be progress, but I would recommend the FOMC go on further and try nominal Gross Domestic Product (NGDP) level targeting. It does what a price level target does and then some. Moreover, it avoids many of the problems inherent to a price stability target.