The Macroeconomic Situation and Macroeconomic Policy: Insiders and Outsiders: Focus
Somebody Is Inside an Echo Chamber. But Who?
Paul Krugman fears that somebody is trapped inside an echo chamber, hearing only things that confirm what they already believe:
Disagreement… over US monetary policy… [between those] very worried that the Fed may be gearing up to raise rates too soon… [and the] sanguine… seems to depend on one thing: whether the economist in question is currently in a policy position…. We don’t have access to different facts; we don’t, in any fundamental sense, have different economic models…
But how can we tell which side has lost contact with the reality out there?
Well, I think–as does Paul–that it is the “insiders” who are being optimistic and unrealistic in their plans to start raising short-term safe interest rates from zero in June 2015 and then, if past tightenings are any guide, raise them to what they regard as a full-employment growth-along-the-potential-path level of 5%/year or so by the end of 2017. One reason is that I do not see a strong world and a weak dollar that would produce a stronger export boom relative to potential, do not see a recovery of relative government purchases to normal levels, cannot envision much stronger business investment without support from other strong components of demand, cannot see the restructuring of housing market finance that would produce even a normal pace of housing construction, cannot see where else durable demand expansion could come from, and fear adverse shocks.
But I do not think we have to decide. I think that even if we are uncertain whether the optimistic “insiders” or the pessimistic “outsiders” are correct, elementary prudent optimal-control theory tells us that we should act as if the “outsiders” are right.
But I have gotten ahead of myself:
Tim Duy says:
…in stark contrast with its… counterparts…. The ECB… quantitative easing, the Bank of England… more dovish… Denmark joined the Swiss in cutting rates… the Bank of Canada…. How long can the Fed continue to stand against this tide?… The Fed should of course be cautious…. But how does the Fed communicate such caution?
The challenge I see for the Fed is that they will want to hold the statement fairly steady…. Such a steady hand, however, may be viewed as hawkish, which is also a message the Fed does not want to send…. Bullard wants to ignore the market-based inflation metrics that would have in the past told him to hold off on any tightening. He really, really wants to liftoff from the zero bound, the sooner the better. I don’t think this level of immediacy is felt by other FOMC members, but I do think they are hoping and praying the data gives them enough to move by mid-year…
And:
…to ‘give them room’ in the next recession is of course self-defeating. They are not going to invite a recession simply to prove they have the tools to deal with another recession. The reasons the Fed wants to normalize policy are, I fear, a bit more mundane: (1) They believe the economy is approaching a more normal environment with solid GDP growth and near-NAIRU unemployment. They do not believe such an environment is consistent with zero rates. (2) They believe that monetary policy operates with long and variable lags. Consequently, they need to act before inflation hits 2% if they do not want to overshoot their target. And they in fact have no intention of overshooting their target. (3) They do not believe in the secular stagnation story. They do not believe that the estimate of the neutral Fed Funds rate should be revised sharply downward. Hence 25bp, or 50bp, or even 100bp still represents loose monetary policy by their definition. I am currently of the opinion that there is a reasonable chance the Fed is wrong on the third point, and that they have less room to maneuver than they believe.
Paul Krugman says:
…to incestuous amplification…. I worry that this is what is happening to the insiders. On the whole, it seems less likely for the outsiders, although it’s true that the Keynesian econoblogs form what amounts to a tight ongoing discussion group that could be doing some amplification of its own…
And:
Unusually, Olivier [Blanchard] and I… have a… disagreement… over US monetary policy…. I’m very worried that the Fed may be gearing up to raise rates too soon; he’s sanguine… part of a wider split… [that] seems to depend on one thing: whether the economist in question is currently in a policy position. Larry [Summers]… sounds exactly like me:
Deflation and secular stagnation are the threats of our time. The risks are enormously asymmetric…. The Fed should not be fighting against inflation until it sees the whites of its eyes….
We don’t have access to different facts; we don’t, in any fundamental sense, have different economic models…. If you ask me, there’s a worrying complacency among the insiders right now, and I would urge them to consider the potential consequences…
So how would we tell whether, right now, it is the outsiders are overstating the dangers to premature tightening, or it is the insiders who are understating the dangers to premature tightening here in the United States?
To answer this question, I think we need to consider five points–the first about our decision procedure, the second about the level of spending consistent with full employment, the third about the degree of uncertainty and variability, the fourth about the vulnerabilities of the economy to spending deviations above and below the projected current-policy path, and the fifth about the effectiveness of our optimal-control levers in different scenarios.
The first point is that if it turns out that we cannot tell–that we have to split the difference–then the considerations that rule are the asymmetries in the situation.
The second point is that no one right now has a good and convincing read on what, exactly, the level of spending consistent with full employment at the currently-projected price level is. Uncertainty is rife: if there was ever a time for considering not just the central tendency of the forecast but the risks on either side and taking optimal control appropriately valuing these risks seriously, it is right now.
The third point is that we are not just uncertain about what the proper full-employment path for demand is, we have much more than the usual amount of uncertainty about nearly all other dimensions of the structure of the economy. To suppose that any of the emergent properties that are policy multipliers can be estimated from data collected during “normal” times is to make an enormous leap of faith.
The fourth point is that downside risks to the forecast greatly exceed upside opportunities. The inflation rate is so low that marginal deviations from the target on the upside have little cost. The employment-to-population ratio is so low that marginal deviations of it on the downside from its projected current-policy path are very costly.
And the fifth point is that, while the Federal Reserve has powerful levers to restrict demand if spending shoots above the desired policy path, its levers to expand demand if spending falls below have been demonstrated over the past six years to be relatively weak.
Thus, if it turns out that we cannot tell–and we cannot tell–then it is not correct that we should split the difference. The considerations that rule are then the asymmetries in the situation. It is, right now, much worse to undershoot than to overshoot full-employment demand: the one causes extra and pointless unemployment, the second disappoints the rentier, and we live in a poor world in which the first is more of a policy error than the second. It is, right now, true that entral banks have a very easy time restricting aggregate demand via contractionary policy but–at and near the zero lower bound, at least–a hell of a time boosting aggregate demand via expansionary policy.
These asymmetries mean that, as far as policy is concerned, the “outsiders” win any tie and win any near-tie: the “insiders” should govern what policy should be only if there is not just a preponderance of the but clear and convincing evidence on their side.
Yet the Federal Reserve appears to have decided:
- that those who think that the economy is near full employment and is in a durable recovery have by far the better of the argument as to what the central tendency projected current-policy demand path is.
- that it is appropriate to make policy via certainty-equivalance.
Given the inability of the Federal Reserve to attain traction at the ZLB, its current frame of mind–which appears to be doing certainty-equivalence policy–makes no sense to me. Certainty-equivalence is appropriate only with a symmetric loss function and a symmetric ability to compensate for deviations on either side of the target. We do not have either of those.
Has there been an explanation of why the Federal Reserve’s policy is appropriate, given the uncertainties, given the asymmetry of the loss function, and given the asymmetry of the control levers, that I have missed? If so, where is it?
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