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

FOMC | More Choices–Rip van Winkle Awakes

Oct. 29, 2014–What's the FOMC going to do today? A quick sampling of forecasts is that it will move away from QE3, its makeshift easy-money policy during the period of zero-bound interest rates.

I've been following the Fed since I worked there and at the FDIC five decades ago as a financial economist.

The latest week's Initial Unemployment Claims, which FRED (the wonderful database of the St. Louis Fed–thank you, James Bullard) graphs for us, has fallen to 283,000.

That's about to where it was briefly in 2000 before the dot-com bubble burst. Not since the early 1970s have initial claims been lower. This suggests inflation should be waiting to ambush us.

It's certainly taken a long time to get to this point. In January 2009, former Fed Governor and inflation hawk Laurence Meyer of Macroeconomic Advisers told a packed luncheon group sponsored by the New York Association for Business Economics that recovery was "at least 18 months away". He wasn't kidding.

Now, nearly six years later, we seem there. Unemployment is below the 6 percent threshold where the Fed historically (using the NAIRU) has started to worry about inflation.

However, wages have not kept pace, which shows slack in the labor market. And, as Paul Krugman reminds us, there are still no signs of overall inflation. (See graph - the Personal Consumption Expenditures chart shows the same pattern.)

So the Fed doves - Chair Janet Yellen, Gov. Daniel Tarullo, and Fed Bank Presidents William Dudley (NY), Charles Evans (Chicago) and Eric Rosengren (Boston) don't want to raise interest rates yet.

They point to the big mistake of FDR's economic policymaking in 1937, when interest rates were raised too soon. Wall Street has an adage: "When the Fed starts to crunch, it's time to go to lunch."

Fed hawks, however - Bank Presidents Richard Fisher (Dallas), Jeffrey Lacker (Richmond) and Charles Plosser (Philadelphia) - are concerned to stay ahead of the curve. They have their eyes on the 1970s when it seemed the Fed had lost control over prices because of the oil crisis... although former Fed Chair Paul Volcker proved in the early 1980s that if you closed your eyes to the temporary pain, the Fed can always dampen inflationary expectations.

At least in the coming months the FOMC will start getting back to the job it is familiar with, controlling T-bill interest rates through open market operations. A zero-bound interest context doesn't leave much latitude for policy options. Larry Meyer in 2009 even suggested, tongue in cheek, that  the FOMC take a long vacation. If they had followed his advice, they would just now be getting back to work. Like Washington Irving's Rip van Winkle, they may find it hard to settle back in to their traditional role after all these years.

FOMC | Krugman and the Liquidity Trap

On December 18, 2008, I reported on a speech by Laurence Meyer of Macroeconomic Advisors in which he said that after the December 16 Federal Open Market Committee statement, the FOMC could go on vacation for two years. In other words, by going to the zero (actually 0-0.25 percent) interest rate policy, the Fed was out of ammunition in the battle for recovery from the financial meltdown. In other words, the United States was in the Japanese liquidity trap.

Paul Krugman wrote an article in 1998 for Brookings with two other economists on the Japanese liquidity trap. In 1999 he posted his prescient thoughts about the possibility of a Japanese-style liquidity trap happening in the United States. He reviewed the assumptions of the traditional IS-LM model and concluded that at the zero-interest bound characteristic of the liquidity trap, the central bank has little power. In order to change expectations, he argues that inflation targeting is the solution - the central bank should plan on a certain degree of significant inflation. That will impose a negative interest rate on passive owners of liquid assets. It will force them to hunt for yield higher than the inflation rate and - assuming the banking system is working properly (which it was not doing in the first decade of this century) - that will prompt owners of liquid assets to invest. Krugman posted again on the liquidity trap in 2010 but with no mention of inflation targeting.

Interestingly, the 12th edition of Baumol and Blinder, Economics: Principles and Policy (South-Western, 2012, 2011) does not include anything specific about the IS-LM model. (Co-author Alan Blinder was formerly Vice Chairman of the Federal Reserve Board.)  The book does not include "zero-interest" or "zero bound" or "liquidity trap" in its index. But it does have  a box on inflation targeting (p. 695), noting that the current Fed Chairman, Ben Bernanke, was a "big advocate" of inflation when he was a Princeton professor. The British Chancellor of the Exchequer sets an inflation target (currently 2 percent) and the Bank of England is required to work towards meeting that target. Stanford Professor John Taylor showed during the Chairmanship of Alan Greenspan that the Fed's decisions could be replicated with a simple guideline, the "Taylor Rule": (1) When the inflation rate is above 2 percent, raise the real interest rate proportionately above 2 percent. (2) When there is a recessionary gap, reduce the real interest rate below 2 percent proportionate to the recession. Baumol and Blinder note that "No central bank uses the Taylor rule as a mechanical rule." But it is a useful guide to what is actually going on.