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Aug 4, 2022

The Worst Thing in the World for the Fed

Neel Kashkari used to be the most reliably dovish member of the FOMC. Now, he is one of its most reliably hawkish members. Why the change of heart? Is he concerned about the long-term effects of high inflation? Has he had an ideological transformation?

The interesting thing is that Fed officials don’t typically have ideological transformations. Thomas Hoenig was a hawk while he was on the Fed, and he’s continued to be a hawk after leaving the Fed. This is in part because monetary policy views are like political views. We see doves as empathic to the average citizen. They want to lower borrowing costs a bit to make their lives easier, while hawks want to protect the purchasing power of the currency at all costs, at the expense of the little guy. It’s pretty rare for a Democrat to become a Republican, and it’s equally rare for a hawk to become a dove or vice versa.

As recently as 2021, Fed President Kashkari said that he wanted to keep the policy rate at zero until at least 2023. But this past Sunday, he said that the recent inflation readings were concerning and that the Fed was still committed to its 2% inflation target. Going on, he said: “We’re going to do everything we can to try to avoid a recession, but we are committed to bringing inflation down and we are going to do what we need to do.” This must be one of the fastest about-faces on monetary policy in the history of the Fed. What is motivating him?

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Go Along to Get Along

Well, for one, inflation went up a lot. While there was no reputational cost for wanting zero rates when inflation was negligible, maintaining this dovish stance in the face of 9% inflation would have been viewed as insanity. It’s possible that Kashkari simply didn’t expect inflation to rise, and when it did, he changed his opinion. Changing your opinion with the arrival of new information is a good thing and shows that you are intellectually flexible. As Ralph Waldo Emerson said, a foolish consistency is the hobgoblin of small minds.

But there were likely political forces at play as well. Lots of people mistakenly believe that the Chairman, Jerome Powell, is some kind of interest rate dictator who gets to arbitrarily choose the future path of the federal funds rate. Nothing could be further from the truth. All the voting (and non-voting) members of the FOMC make these rate decisions by consensus. It’s pretty rare for a single committee member to maintain a far out-of-consensus view, dissenting at rate decisions along the way. Investors view dissent with some skepticism, and dissent undermines confidence in the Fed as an institution. For Kashkari to continue to vote against rate hikes while inflation was ramping would have undermined both his and the Fed’s credibility, regardless of his personal feelings on the topic. It would have been a career-ender.

That brings me to my next point: If Kashkari has any ambitions of one day moving up in the organization and becoming Chairman, those ambitions would have been dashed if he didn’t go along with the group. It’s simply organizational politics; you go along to get along. Consensus is valued more highly than being right. Pretend that Kashkari still held dovish monetary policy views, voted against rate hikes for a series of meetings, and ended up being vindicated as the economy entered recession and the rate of inflation went below zero. Being right would be viewed more negatively than simply going along with the consensus.

Losing Face

I have always said that trading short-term interest rates is the easiest thing to trade in the world because all you have to do is predict the reaction function of a group of people who are seeking to minimize embarrassment. The Fed lost credibility when inflation rose sharply, and losing face is the worst thing in the world for the Fed.

The Fed is frequently driven by politics or optics. For example, even though there is a lot of economic data that says the economy is weakening, it can’t be seen easing monetary policy while inflation is 9% going into the midterm elections. So, the Fed will continue to raise rates long after it is necessary, and it won’t start cutting them until an expansion is well underway. All of this serves to increase the volatility of the business cycle—hiking when it should be easing, and vice versa. Political concerns were much less of a factor during the Greenspan years when the Fed worked proactively.

Personally, I am happy Kashkari changed his monetary policy views—his transformation benefited us all. I just wonder why. It takes courage to abandon your closely held personal views, but it also takes courage to dissent. There should be more courage in central banking these days because hard decisions are often the right decisions.

Speaking of right decisions…

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Jared Dillian