Should-Read: B.G.: Because I said so: Why the Fed is likely to raise rates, despite low inflation

Should-Read: The surprising thing about B.G.’s long and convoluted Fed-hiking-interest-rates-to-punish-market-like-taking-away-LEGOS-to-punish-misbehaving-toddler metaphor is this: the markets have not misbehaved.

It is as if the parent (Federal Reserve) said: “you, toddler, are going to misbehave” (inflationary pressures will emerge), so I will take your LEGOS away (raise interest rates).” Yet the toddler does not misbehave (inflationary pressures do not emerge). But even so the parent (Federal Reserve) then says: “I have to take your Legos away because I said I would (I have to raise interest rates because I said I would), even though you did not misbehave (even though inflationary pressures did not emerge).”

This certainly gains you a credible reputation.

But is it really the kind of credible reputation you actually want to have?

And yet B.G. thinks that this is a normal and acceptable way to behave…

And at this point I suggest that the entire FOMC—and B.G.—enroll in Daniel Davies’s One-Minute-MBA course, and that the Federal Reserve print up the $30,000 fee for each of the 19 notional FOMC meeting principal participants, and pay it to him…

B.G.: Because I said so: Why the Fed is likely to raise rates, despite low inflation: “Like a parent teaching a child it means business, the Fed may feel it must hike to preserve its credibility with financial markets…

…CREDIBILITY is a thing you have to worry about with toddlers. You cannot reason with them. The best you can hope to do is respond consistently to undesirable behaviour. Get this wrong and your work becomes harder. If your correspondent doesn’t actually go and hide the box of Legos every time he has to count to three, for example, his child will not find his threats to be credible, and will fail to respond to them. This is the problem the Federal Reserve has now with financial markets…. Having told the market what it’s going to do with the Legos, does it now have to do just that, even if it’s a bad idea?… If the committee doesn’t care what markets think, there’s not much of a case for hiking….

When it meets next week, the FOMC will be concerned about two things. First, it must follow its mandate, keeping unemployment low and inflation within reason. Here, there is not much of an argument to do anything. Second, however, the committee wants markets to continue to believe that it will do what it has said. Even though the Legos are not causing a problem just now, it feels pressure to take them anyway to show it means business. Yet while it may hope that in doing so it will preserve the ability to threaten Lego removal in the future, its actions are not without risks. Markets, like toddlers, could fuss, throw tantrums and break things…


Brad DeLong


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