I figure I've logged about 1600 miles of driving in the last 11 days. That cuts into the time available for blogging. Things should improve now for a while at least.
Yesterday, I was in Chicago with my students competing in the 7th District College Fed Challenge. Three time defending national champion Northwestern University won again. Although the University of Chicago certainly gave them a run for their money. We faced U of C in the first round and thus didn't advance. Even so, the value of the program as a learning experience for our students is tremendous.
Fredric Mishkin spoke yesterday about the risk management approach to monetary policy decisions. This was the basis for the lead off question in the final round Q and A session at the Fed Challenge. By the way, all of the final round teams (in addition to our team), were unanimously in favor of holding rates constant at this point in time. The competition is real-time. Therefore having it so soon after the last meeting does sort of predispose one to holding steady. However, there was a lot of discussion and debate by all the teams about what the outlook is going forward.
As for that outlook, Tim Duy is concerned.
...One has to imagine that the Fed must be feeling a little uneasy about pulling the trigger on another 25bp last Wednesday given Friday’s employment report. Still, they likely take comfort in the belief that they drew a line in the sand with the statement, declaring a balanced risk outlook.
But can they stick to that line during a scary four months? Can they look through to that period of “moderate growth” that they keep predicting? I would like to believe they are ready to stick to their guns, but recent history is not on my side.
...
Can the Fed resist that pressure to keep cutting even if they are confident that the medium term risks are really balanced? If the “risk management” faction at the Fed continues to hold power, it seems like more rates cuts are likely, especially if there is any hint of further softening in employment or investment. That is what recent history tells us.
Standing in the way of additional cuts, however, is these new-found inflation concerns that appeared in the last statement. Declining core-inflation has been cited as a justification for Fed easing based upon decreasing estimates of the neutral Fed funds rate. I would only like to suggest that the recent history of core-PCE is not all that comforting. Looking a three-month inflation trends on an annualized basis:
I detect something of an upward trend in the past four months, on the order of 50bp – perhaps it is too early to be lowering estimates of the neutral rate? Personally, I wouldn’t break out the champagne on the inflation story just yet. It appears, however, that Fed Chairman Ben Bernanke and Governor Frederick Mishkin – the power couple in the “risk management” regime – already popped the cork.
The chart is from Duy's post at Economist's View.
This is precisely a point that was made by my students as well as most of the other teams at the Fed Challenge yesterday. This is a concern going forward. There is a very real risk that any further easing could have nasty repercussions for intermediate to long term inflation expectations. And if the Fed is going to be facing a real inflation problem in a year or two, when the economy is still trying to right itself from the subprime debacle, that's not going to be good for growth either.
See also this article by Bloomberg's John Berry.
At this point, I agree. The change of heart from my Taylor rule comes after noticing how rapidly commodity prices have risen over the past 2 months (8/31 to 10/31 was the largest two month month-end-to-month-end percent increase in the CRB index since 1975). In the end, the Taylor rule has to be forward-looking, and the reasonable expectation is that the core inflation rate will rise as higher costs work their way through the economy. (In my ideal world, though, the Fed would be targeting unit labor costs and wouldn't have to worry about commodity prices, in which case I would still advocate substantial additional cuts.)