by Calculated Risk on 2/07/2008 01:06:00 PM

Dallas Fed President Richard W. Fisher spoke in Mexico today: Defending Central Bank Independence. Here are his comments on why he voted against the rate cut last meeting:

At the last meeting of the FOMC, I voted against lowering the federal funds rate—the target rate we set for banks to loan overnight money to each other—from 3.5 percent to 3 percent. The minutes of that meeting will be released on Feb. 20, 2008. It would be inappropriate for me to discuss the deliberations; however, I can give you a perspective.

I spoke earlier of [former Fed Chairman] William McChesney Martin. He famously said that the job of a good central banker is to take away the punchbowl just as the party gets going. For the past few years, we have had a raucous party of economic growth fueled by an intoxicating brew of credit market practices that financed a housing boom of historic, and late in the cycle, hysteric, proportions. With the benefit of perfect hindsight, some have argued that the Fed failed to take away the punchbowl as the subprime party spun out of control, leaving rates too low for too long and not using our regulatory powers to restrain excessive complacency in the pricing and monitoring of risk. But that is beside the point.

Now we are faced with the consequences of a process that lawyers would call the “discovery phase”: As big banks and other financial agents confess their acts of fiduciary omission and excesses of commission, credit markets have effectively de-leveraged important segments of the economy, slowing growth suddenly and precipitously. Instead of taking the punchbowl away, the Federal Reserve is now faced with the task of replenishing the punch.

Yet at the same time, we are faced with the unprecedented consequence of demand-pull inflationary forces fueled by the voracious consumption of oil, wheat, corn, iron ore, steel and copper, and all other kinds of commodities and inputs, including labor, among the 3 billion new participants in the global economy. When it comes to these precious inputs, we have no control over the surging demand from China, India, Brazil, the countries of the former Soviet Union and other new growth centers, but we know that it is putting upward pressure on prices in our economy. Economists note that the “income elasticity of demand” for food is higher in China and other emerging economies than in the United States. Many of these countries’ income elasticity of demand for oil and certain other vital commodities is greater than 1, meaning that their demand for these items will increase faster than their income. Even if growth slows somewhat in some of these important emerging economies—the World Bank, for example, projects China’s growth will be 9.6 percent in 2008, down from 11 percent last year—demand for inputs relative to the world’s ability to supply them will likely continue to exert upward pressure on key commodity prices.

We also know that the inflationary expectations of consumers and business leaders are impacted by what they pay for gasoline at the pump and food at the grocery store.

Monetary policy acts with a lag. I liken it to a good single malt whiskey or perhaps truly great tequila: It takes time before you feel its full effect. The Fed has to be very careful now to add just the right amount of stimulus to the punchbowl without mixing in the potential to juice up inflation once the effect of the new punch kicks in.

We have been hard at work trying to find the right mixture. Before the meeting last week, we had reduced the fed funds rate by 175 basis points in 18 weeks—cuts that I supported even though I did not have a formal vote. During that time, we also initiated a new system for term money that has auctioned $100 billion at rates below the official discount rate.

My dissenting vote last week was simply a difference of opinion about how far and how fast we might re-spike the monetary punchbowl. Given that I had yet to see a mitigation in inflation and inflationary expectations from their current high levels, and that I believed the steps we had already taken would be helpful in mitigating the downside risk to growth once they took full effect, I simply did not feel it was the proper time to support additional monetary accommodation.

That is two voting members expressing serious concerns about inflation.

However, it appears the market isn't listening to Fisher, or Plosser's "damn the torpedoes, full speed ahead" speech yesterday:

"Unfortunately, I expect little progress to be made in reducing core inflation this year or next, and I am skeptical that slower economic growth will help. ..."

Click on graph for larger image.

According to the Cleveland Fed, the market expectations are centered on an additional 50 bps cut in the Fed Funds rate in March to 2.5%.