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

YELLEN | Perfect Choice for Fed

Janet Yellen, President Obama's

nominee for Fed Chair

The appointment of Janet Yellen is perfect because she is pragmatic, eyes on the data, and concerned about unemployment as well as inflation. She is not one of those central bankers who consider the unemployment problem to be a secondary concern.

Also, because she is a woman, we won't be hearing so many complaints about "100 years of patriarchy at the Fed".

While the Phillips Curve has given way in academic circles to the concept of a non-accelerating-inflation rate of unemployment (the NAIRU), the two desirables of low inflation and low unemployment remain the twin objectives of the Fed, with low inflation being the traditional central bank goal and a low-unemployment goal having been added by the Employment Act of 1946.

Inflation appears to be under control, so the "doves" on the Federal Open Market Committee believe that it is not yet time to "taper" the Quantitative Easing program that has been designed to encourage economic growth. The idea is to keep long-term interest rates low by providing a ready secondary market for long-term Treasuries, thereby lowering yields on all long-term instruments and providing inexpensive capital for job-creation.

In a fine interview a few hours ago on Charlie Rose, Professor Yellen emphasized that the Federal Reserve is working on behalf of all Americans. The implication of that is that containing inflation satisfies the concerns of those who hold debt, i.e., wealthier Americans. Unemployment, however, is more prevalent among poorer people and it creates poverty.

That, in a word, is why the doves tend to be liberal Democrats and the "inflation hawks" tend to be more banker-oriented. Yellen is close to Bernanke on this spectrum, but more dovish than Bernanke has appeared to be recently in his effort to preserve consensus.

The target rate for interest rates continues to be near the zero bound because inflation is coming in below the 2 percent target that Chairman Bernanke announced at the beginning of 2012. Right now 6.5 percent still appears to be the target unemployment rate, and we are not there yet, although we lack the September number because of the government shutdown. By the standards of the targets, based on the data, Janet Yellen is in the right place on the dove-hawk perch.

A few critics from the left note that she did not oppose the 1999 takedown of the Glass-Steagall Act, but then neither did Senator Schumer and other key Democrats. No one fully foresaw how things would play out through 2008. It was the London Economist that in 1999 observed correctly that if the investment banking (and other non-bank financial) foxes were allowed to mingle with the banks, the investment banks – or preferably the entire financial system including the investment banks – should be regulated. For more on this period, see this post from 2008.

How to Measure Hurricane Sandy's Damage

Indian Wells Beach, East Hampton, NY, 10-29-12.
Photo by JT Marlin.

What is the cost of Hurricane Sandy compared with Hurricane Irene? A number of estimates are already appearing and the dollar amounts are already very large. My concern is that erroneous statements were made about Hurricane Irene that should not be repeated, for example that it was the fifth-costliest hurricane on record. A ranking based on dollars that does not adjust for inflation is just not useful.

The suggestion has already been made that this will be the costliest East Coast hurricane ever. The Wall Street Journal has compared satellite photos of Sandy and Irene and shows that Sandy is much larger.  The WSJ concludes that Sandy will cost more than its estimate of a $15 billion cost for Irene. On the other hand, television interviews with officials in Westchester indicate that Hurricane Irene was more severe.

Advance Measures of Danger

At the moment two main measures of the significance of a storm are provided by meteorologists. They are interrelated and both point to likely wind speeds. The public needs at least one more  measure that shows the likely economic impact of flooding, and I suggest under the third heading below what the measure might look like.

1. Wind-Speed Category. A Category 1 hurricane means wind speeds of 74-95 mph on the Saffir/Simpson Hurricane Scale. Hurricane Irene petered out on its way north. Hurricane Sandy on its way north has been affected by two other independently originating storms, as well as by tidal factors.

2. Barometric Pressure. The Christian Science Monitor has posted a lucid summary of the importance of this measure of hurricane severity. (It also repeats the error cited above about the cost of Hurricane Irene - I will return to this.) Ordinarily, the barometric pressure is related to wind speed. The normal sea-level barometric pressure is 1013.5. During a hurricane the eye of the storm shows the lowest barometric pressure. The lower the pressure, the higher the winds. During the afternoon today, the barometric pressure at the eye of Hurricane Sandy fell from 943 to 940, which is a level associated with Category 3 or Category 4 winds. The lowest barometric pressure that has been measured in a U.S.hurricane is 882 for Hurricane Wilma. Hurricane Carla was the tenth-lowest, 931. The National Hurricane Center list of the most intense hurricanes does not follow the Millibars ranking exactly, since Katrina and Wilma are not in the order one would expect.

                                        Ten Most Intense Hurricanes

Name (After 1953) or Location	Year	Category	Millibars
1.Florida Keys	1935	5	892
2.Camille	1969	5	909
3.Katrina	2005	3	920
4.Andrew	1992	5	922
5.Indianola, TX	1886	4	925
6.Keys, FL	1919	4	927
7.Lake Okeechobee, FL	1928	4	929
8.Donna	1960	4	930
8.Miami, FL	1926	4	931
10.Carla	1961	4	931

Notes: Wind Category is at Landfall. Category 5 on the Saffir/Simpson scale means >155 mph winds for at least one minute. Category 4 means 131-154 mph for at least one minute. Category 3 means 111-130 mph for at least one minute.  Millibars are mercury readings of barometric pressure.
Source: Based on NOAA, National Weather Service, National Hurricane Center, Blake and Gibney, 2011.

3. Flood Surge Impact. However, most of the damage is caused by the delayed impact of the flooding surge (the hurricane equivalent of a post-earthquake tsunami). We need a new indicator of likely flood damage, which would have to take into account the economic value of property in the track of the hurricane, the sea level of the land, and the size of the expected surge.  The Flood Surge Impact index could take into account the tides (the full moon is adding to the surge) and the geography of the surge.

Retrospective Measures of Cost

There are seven basic ways to measure and adjust the cost of a hurricane. They overlap:

1. Loss of Life, or Injury.  On the simple measure of number of lives lost to a hurricane, Hurricane Irene did not even rank among the 100 most costly hurricanes. Preparedness is much better than it used to be and saving lives is a priority. Mayor Bloomberg has made clear that the overriding priority of the City of NY is to avoid loss of life. Hurricane Irene took one life and as far as Mayor Bloomberg is concerned that was one too many. The mayor has generated a scientific approach to evacuation based on flood probability maps. Also contributing to reduced fatalities is the steady improvement in U.S. Government warning systems via the National Weather Service and the National Hurricane Center,  and the FEMA network of state notification and assistance.  Loss of life can be converted to a dollar figure via life insurance losses or a value that economists impute to a person's remaining working life. Injuries also represent a cost either to the individual or to health insurance plans (private or governmental), and injuries that result in a disability have a working-life cost that can be attached.

2. Loss of Physical Property.  Property can be destroyed by wind or flooding or a combination. This means a loss of wealth of the property owner. If the loss is charged against revenue, it means a loss of revenue. (A building may be a depreciated asset; loss of inventory is likely to be expensed.) The first impact may be flying debris, the lifting off of roofs, the flattening of flimsily constructed buildings. The delayed effects include (a) loss of electricity from downed power lines, which means that many perishables have to be thrown out, and (b) flooding, which destroys or rends temporarily useless all kinds of property such as books and electronics, especially if the flooding is from salt water, which MTA Chairman Joe Lhota says is especially damaging to rail signal and power connections. It also includes business interruption, which is the next category.

3. Business Interruption. Increasingly, businesses insure not only against loss of property but the loss in profits that comes from an interrupted business. When a restaurant or a theater remains closed because of floods that prevent people from showing up, it is hard to make up the loss because the business space has a limited capacity. Figures on the cost of hurricanes increasingly include business-interruption losses, which bias upward the later numbers.

4. Insured vs. Uninsured Losses. Insurance companies are most interested in the total of insured losses. But from an economic perspective, losses to individuals (e.g., workers paid by the hour) are real. The money that would have been spent in the community by the individuals is missing. The National Hurricane Center uses a simple formula to estimate uninsured losses - it doubles the number for insured losses.

5. Private vs. Public Insurance. Flood insurance is provided by the National Flood Insirance Program as a last resort because private insurers have been reluctant to provide it. Individuals pay a premium for this insurance. After a hurricane, there will be payouts. FEMA programs also provide relief to individuals. The National Hurricane Center in its estimate of damage adds in a number for flood damage provided by the National Flood Insurance Program.

6. Federal, State and Local Assistance. Emergency assistance by FEMA, other Federal bodies (the Army Corps of Engineers, for example), states (emergency response teams) and localities (police, fire, sanitation, ambulance) must be factored in as costs.

7. Adjustments for Inflation, Business Activity. Two kinds of adjustments are typically made to comparisons among hurricanes. One is to adjust cost figures for inflation. The Christian Science Monitor story cited above incorrectly describes Hurricane Irene as the fifth mostly costly hurricane in U.S. history. As I explained last year, that label only works if we are under the delusion that a dollar 100 years ago should be valued the same as a dollar today. (Apart from the fact that business-interruption costs are increasingly included in hurricane losses, adding to the size of the numbers.)  There are widely available cost-of-living indicators to refer to, such as this one from the BLS. The business activity measure relates the hurricane to the value of the real estate through which the hurricane travels. This is a good predictor of cost and is also a factor to consider in comparing the impact of a hurricane traveling the same path in different years.

I have written on this topic last year on Huffington Post and my CityEconomist blogsite.

IRENE | Is It One of Top Ten U.S. Catastrophes?

The New York Times today has Irene pegged as one of the "top 10 costliest catastrophes in the nation's history". To rank losses over time, they must at a minimum be adjusted for inflation. Irene imposed huge losses on many communities, but does it rank among the "Top 10 costliest catastrophes in the nation's history"? At the $7-$10 billion total cited in the article, no way. If the losses remain in this range after all reports are in, Irene will not even rank among the top ten Atlantic Coast hurricanes.
Adjusting for inflation only:
- The tenth costliest hurricane since 1900 was Betsy in 1965, with $11.2 billion in 2010 dollars.
- Katrina ranks #1 at $105.8 billion.
Adjusting for population growth and wealth per capita as well as inflation, as two experts argue is needed to compare the data on a fair basis:
- The costliest hurricane since 1900 was the 1926 Great Miami hurricane, with losses of $164.8 billion in 2010 dollars.
- Katrina is second at $113.4 billion.
- The Galveston 1900 hurricane is the third most severe, with a loss of $104.3 billion.
- The tenth costliest was Hurricane Donna in 1960, with a loss of $28.2 billion in 2010 dollars.
SOURCE: Eric S. Blake (National Hurricane Center) and Ethan J. Gibney (National Climatic Data Center), The Deadliest, Costliest and Most Intense U.S. Tropical Cyclones from 1851 to 2010, April 2011, Table 3b, p.11.

U.S. MISERY INDEX | 8.3 Percent

Fed Chairman Ben Benanke has warned Congress both about the possibility of higher inflation and a recession in the near future. Higher inflation would arise in part from costlier commodities imports (reflecting the declining value of the dollar and the higher cost of oil). A recession could be induced by falling housing prices and the impact of foreclosures and writeoffs on credit markets.

The danger of a combined higher inflation and unemployment is stagflation, measured by the so-called "misery index", which was at its highest in June 1980 at 22 percent and at its lowest in July 1953 at 3 percent. In October, U.S. inflation was 3.6 percent at a seasonally adjusted annual rate (SAAR). The unemployment rate was unchanged at 4.7 percent. The misery index was therefore 8.3 percent.

In New York City, the unemployment rate rose in October to 5.3 percent, seasonally adjusted, an increase from 5.1 percent in September 2007. With NYC inflation at 3.1 percent year-over- year, its misery index is a relatively low 8.4 percent, just 0.1 of a percentage point higher than the nation's.

NYC is still in the early stages of a housing downturn and financial sector mass layoffs. BLS reports that third-quarter "layoffs in the finance sector were primarily in the credit intermediation and related activities industry, which reported its highest number of events and separations in program history.”