Sunday, June 4, 2017

FOMC | Questions About Fed Models

Gov. Lael Brainard (top center) addressing the NYABE,
Cornell Club, NYC, May 30, 2017.
On Tuesday, Federal Reserve Board Governor Lael Brainard spoke to the New York Association for Business Economics. 

At the heart of the Federal Reserve System is the Federal Open Market Committee (FOMC), which since the days of Ralph Young in the 1950s and 1960s has, as its primary task, engaged in carrying out open market operations in Treasury bills to influence interest rates.

The idea behind FOMC intervention in the marketplace is that the Fed can fine-tune the economy, by buying Treasury bills to inject cash and lower short-term interest rates, or by selling Treasurys to remove cash and raise interest rates. 

Lower interest rates create "easy money" and that is supposed to encourage investment. However, the Fed has been at the "zero bound" in its interest-rate targeting since its statement of December 16, 2008. I wrote a piece for Huffington Post  on January 17, 2009, that quoted former Fed Vice-Chair Laurence Meyer. Speaking to the New York Association for Business Economics, Meyer said that the FOMC could go on vacation "for the next two years" until it lifted off from its zero-bound policy.

It's been more than eight years now and the Fed's interest-rate target is still below 1 percent. A quarter-point increase is expected at the next FOMC meeting in mid-June.

The worry about raising interest rates is that it will discourage investment, and also that in the absence of inflation it is not necessary. 
A full table of reporters in the back.
Bloomberg, Dow-Jones...

It is a time when basic questions are being asked about the implicit model on which FOMC model is based. Is it possible that the model-builders have lost touch with the data on which the models are based? Is inflation understated, for example?

After the lunch I asked Gov. Brainard what she thought about this. Her answers were helpful:
Marlin: "When I was working at the Federal Reserve Board more than fifty years ago..."
Brainard: "Fifty!?"
Marlin: "Fifty, under Chairman William McChesney Martin. The prevailing faith then was that higher [but moderate] inflation would encourage demand, and lower interest rates would stimulate investment. Is this still the faith?"
Brainard: "I think we are less confident now than we were then."
Marlin: "Is that because of a new theory, or less faith in the data?"
Brainard: "It's not because of change in the theory. It's more a question of alternative views about the econometrics, rather than the data."
The data and econometric issues are related, because models use high-level aggregate averages. For example, "inflation targeting" at 2 percent per annum is based on a few overall-average price levels. The expansion of the money supply during and after 1933 is given full credit by Christina Romer for the stimulus to the economy that ended the Great Depression.

But what if average-price components move in different directions and then one of them changes direction? As the economy changes, the time horizons over which averages are computed may also need to change. Here are some charts from the "Fed Dashboard" of how prices have been diverging.

Similarly, both the slow response of the economy to massive new debt creation since 2008 and the zero-bound interest target from January 2009 raise questions about the Keynesian narrative in changed financial markets. The markets responded as predicted when short-term interest rates were hiked, but lowering rates to the zero bound did not spur investment as expected.

If the theory on which FOMC policies are based hasn't changed, and interest-rate and inflation-targeting policies based on the theory have not achieved their goals, doesn't that imply problems with the models or the data?

Related Posts: FDR Nullifies Gold Contracts . Glass-Steagall . FDR's First Fireside Chat