Musings on the Current Episteme of the Federal Reserve...
Larry Summers attributes the Federal Reserve's decision to tighten policy, in what appears to him and to me to be a weakly-growing and high-slack economy, to four mistakes, which are themselves driven by a fifth, overarching mistake. The four mistakes are:
- The Fed has much too much confidence in its models that tell it that the unemployment rate takes the temperature of the labor market and the Phillips Curve now still has the slope it had in the 1970s.
- The Fed operates as though FOMC members are tased whenever inflation rises above 2%/year, with no countervailing painful consequences of low inflation, low employment, or low output.
- The Fed believes--without empirical support anywhere that I can see--that quick sharp moves up or down in interest rates have larger effects in total than the same interest-rate change made gradually and over a longer term.
- The Fed thinks--without theoretical support that I can see--that zero interest rates are not a reflection of an economy in a pathological state, but rather a cause of economic pathology that is dangerous now that the economy is once again "normal".
And Summers sees the fifth, overarching mistake the Fed is making right now as:
(5) The Fed is excessively committed to "existing models and modes of thought... in the thrall of orthodoxy":
My Views and the Fed’s Views on Secular Stagnation: "First, the Fed assigns a much greater chance that we will reach 2 percent core inflation...:
...than is suggested by most available data.... Second, the Fed seems to mistakenly regard 2 percent inflation as a ceiling not a target.... Third, the Fed seems to be in the thrall of notions that... do not... have analytic support premised on the idea that the rate of change of interest rates, as distinct from their level, influences aggregate demand.... I know of no model in which demand will be stronger in say 2018 if rates rise and then fall than if they are kept constant at zero. Nor... do I know of a reason why recession is more likely if the changes are backloaded.... The argument... is in the category with the argument that I should starve myself in order to have the pleasure of relieving my hunger pangs. Fourth, the Fed is... overestimating the neutral rate.... The desire to raise rates reflects... a sense that zero rates are a sign of pathology and an economy creating 200,000 jobs a month is not diseased....
Why is the Fed making these mistakes if indeed they are mistakes? It is not because its leaders are not thoughtful or open minded or concerned with growth and employment. Rather I suspect it is because of an excessive commitment to existing models and modes of thought...
I do think--confidently--that Summers is absolutely 100% correct in his identification of the four component intellectual errors that the Federal Reserve is currently making. And it is certainly true that these are the result of an excessive commitment to some current modes of thought--there are, after all, a lot of people who join the Fed in thinking that zero interest rates are a cause rather than the proper treatment of pathology right now, that the Fed needs to raise rates now to give it the space to lower them if need be later, that it is dangerous for inflation to rise above 2%/year ever, that the Phillips Curve somehow has a steeper slope than the recent evidence of the past generation can justify belief in, and that the unemployment rate rather than the detrended employment-to-population ratio gives the temperature of the labor market.
But do these beliefs on the part of the Fed really reflect an excessive commitment to existing models? There I have my doubts. Or, rather, it depends on what you think the proper function of economic modeling is. Are models properly idea-generating machines, in which you start from what you think is the case and use the model-building process to generate new insights? Or are models merely filing systems--ways of organizing your beliefs, and whenever you find that your model is leading you to a surprising conclusion that you find distasteful the proper response is to ignore the model, or to tweak it to make the distasteful conclusion go away?
Both can be effectively critiqued. Models-as-discovery-mechanisms suffer from the Polya-Robertson problem: It involves replacing what he calls "plausible reasoning", where models are there to assist thinking, with what he calls "demonstrative reasoning". in which the model itself becomes the object of analysis. The box that is the model is well described but, as Dennis Robertson warned,there is no reason to think that the box contains anything real. Models-as-filing-systems are often used like a drunk uses a lamp post: more for support than illumination.
In the real world, it is, of course, the case that models are both: both filing systems and discovery mechanisms. Coherent and productive thought is, as the late John Rawls used to say, always a process of reflective equilibrium--in which the trinity of assumptions, modes of reasoning, and conclusions are all three revised and adjusted under the requirement of coherence until a maximum level of comfort with all three is reached. The question is always one of balance.
But it is clear to me that if you give even minor weight to the first--see well-founded models as a way of generating new insights rather than just organizing old beliefs--that the line of work into the economics of the liquidity trap that I see as well-represented by Krugman's (1999) "Thinking About the Liquidity Trap" tells us, very strongly, that the Federal Reserve is on the wrong track intellectually right now. It tells us that what is out of whack has not been and is not the real money stock, but is instead the expected inflation rate. Or, rather, that because the expected inflation rate is too low, there is no value of the real money stock consistent with full employment equilibrium. If expected inflation were higher, the existing money stock would be ample, or even require shrinking.
This is the conclusion of Krugman (1999): that the economy needs higher expected and actual inflation, and that the free-market economy with full price flexibility would deliver that inflation. But the Fed does not appear to acknowledge either that the economy needs higher inflation, that the flexible-price benchmark would deliver this inflation, or that the job of the Fed is to mimic that full employment-generating price structure as closely as possible.
Moreover, the Fed does not engage in reflective equilibrium. It rejects the conclusions of what I regard as the standard Patinkin-style existing model of Krugman (1999). But it does not propose an alternative model. There seems to me to be no theoretical ground, no model even considered as a filing system, underpinning the "orthodox" modes of thought that the Fed believes. And it does not seem to feel this absence aaa a problem. I find that somewhat disturbing.