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Procrastinating on June 24, 2016

Uncertainty at the Federal Reserve: No Longer So Live at Project Syndicate:

No Longer so Live at Project Syndicate: I find myself increasingly believing that the side of the scale that says the Federal Reserve is in the process of losing its credibility is the heavier. And this past week added another weight to that side of the scale. Over at Bloomberg View the very sharp Narayana Kocherlakota, former President of the Federal Reserve Bank of Minneapolis, writes:

Narayana Kocherlakota: Ending an Unhealthy Obsession With the Fed: "The obsession with the Fed...

...Outsiders are seeking clues to the central bank’s broader goals.... The Fed’s stated aim... [is] inflation at 2 percent... but its actions send a different signal... [they] removed stimulus... even as inflation and inflation expectations have slipped downward... [their] economic projections... suggest that they don’t see getting inflation back up to target quickly as a primary determinant of monetary policy.... The Fed is balancing the pursuit of its inflation target with other objectives... [that they fear] low interest rates are causing risks and distortions... [that they] don’t want the unemployment rate to fall to an unsustainably low level... [that] raising rates at every meeting... could be too much of a shock.... It’s hard to know which objectives will dominate policy in the longer run. Hence, markets are parsing the June decision for whatever information they can get. This kind of uncertainty... is not healthy...

Narayana is correct. But I think he leaves unstated a good deal of the problem, for we face more than simply uncertainty about Federal Reserve policy objectives.

Briefly, as I see it:

  1. Participants in financial markets do not know what is the true state or the true model of the economy.
  2. The Federal Reserve does not know what is the true state or the true model of the economy.
  3. Participants in financial markets do not know how the Federal Reserve will update its view of the current state of the economy and its view of the true mode of the economy as information comes in.
  4. Participants in financial markets do not understand which out of of the many other possible objectives beside rough price stability and maximum feasible employment the Fed is going to pursue in practice.
  5. Thus participants in financial markets do not understand why the Federal Reserve is doing what it is doing, or how its policies will react to events in the future.

In an environment of such radical uncertainty, a prudent central bank attempting to pursue optimal control would, right now, be doing everything it could to raise expected and actual inflation so that it can then rapidly move its policy interest rate to a position in which it has freedom to act to stabilize the economy in any direction--to raise interest rates further in the case of overheating and accelerating inflation, and to lower interest rates in response to adverse demand shocks.

But the Federal Reserve is not being prudent in this sense. Rather than pushing for inflation at or above its target to give it room to respond to future surprises in the form of shocks, in the form of new knowledge about the state of the economy, and in the form of new knowledge about the right model, it is removing accommodation and champing at the bit to remove more.

And the Federal Reserve does not seem to be updating its view of the economy in an understandable way. Consider that as of June 2013 the Federal Reserve was anticipating that GDP growth over 2013-2015 would average 2.9%/year, with a longer-run rate of growth of real potential GDP of 2.4%/year. It foresaw a PCE deflator inflation rate of 1.9% for 2015. Its average projection of the Federal Funds rate for 2015 was 1.5%--and it foresaw a longer-run 2016 and beyond level of the Federal Funds rate of 4%. Instead, growth has averaged 2.3%/year--2.2%/year adding in what we expect for the first half of 2016. The 2015 PCE deflator inflation rate was 1.5%. The Federal Funds rate is currently at 0.25%. And the average projection of the longer-run Federal Funds rate is down to 3.25%.

FRB June 19 2013 FOMC Projections materials accessible version

This three-year consistent undershoot of the economy relative to Federal Reserve expectations since 2013 follows a previous three-year undershoot since 2010, which itself follows a three-year period starting in 2007 in which the Federal Reserve massively understated downside deflationary risks. Those events should have triggered substantial movement in the Federal Reserve's model of the economy. Indeed, there are now ritual and more-than-ritual bows in the direction of Hyman Minsky and financial fragility. And there has been a secular stagnation-driven lowering of the longer-run estimate of the Wicksellian neutral late-boom Federal Funds rate from 5% to 3%. But there seems to be little change otherwise: the same relative neglect of asymmetry as only a second- or third-order phenomenon, the same high gearing of inflation expectations to past inflation, the same assumed relatively steep slope of the Phillips Curve, and the same reliance on the unemployment rate at the expense of other indicators as a near-sufficient statistic for the state of the labor market.

The Federal Reserve has been consistently more optimistic than market-price expectations about the available headroom for raising interest rates. Financial market participants have taken this to mean not that the Federal Reserve has been unlucky, but rather to mean that the Federal Reserve's model of the economy and understanding of the current state of the economy is wrong. They are expecting the Federal Reserve to update its model in the future as the data continues to come in. But in their view the Federal Reserve has failed over the past six years to convey how the data has led them to update their model, and why they have made the model-revision choices they have.

Thus we fact not just Federal Reserve objective uncertainty, we face Federal Reserve model-updating uncertainty. The Federal Reserve must, I believe work very hard to tell us more not just about what its key objectives are--normalizing interest rates to support the commercial banking sector, hiking rates to curb speculation, avoiding even a temporary fall in unemployment below a sustainable level, maintaining a very smooth path for the Federal Funds rate, and several others--but how it is going to respond when the future disappoints its expectations on one side or the other, and it must once again update its internal model of the economy.

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