I was arguing in the last post that forecasts are much less useful for monetary policy than people think. This is of course anathema and unthinkable to many people. The most fashionable current monetary framework, inflation targeting (or potential variants like nominal GDP targeting) are entirely reliant on forecasting the economy 1-2 years ahead. Hundreds of people are employed in central banks to do such projections. The process has the surface appearance of rigor and seriousness and technical knowledge. Monetary policy only has an impact with a lag, and those lags are famously long and variable. So, the argument goes, use of forecasts is essential.
This is almost universally accepted, but dead wrong. People overemphasize the relatively consistent lag and underemphasize the “variable” element. It is not just that economic forecasts of the future are notoriously inaccurate and unreliable. Our understanding of the transmission process from policy instruments to the real economy is also alarmingly vague, as the debates over the impact of QE showed.
That is an argument for caution, rather than technocratic overconfidence that we can predict inflation or GDP to a decimal point or two two years out. A less overconfident central bank is less likely to make serious policy errors. The development of precise models and projections tends to make people highly overconfident, however.
Standard academic thinking about monetary policy, with its targets and policy rules, is in fact a generation behind the rest of society. Most of business abandoned formal, rigorous planning methods based on forecasts and targets in the 1980s and 1990s, as Henry Mintzberg showed. Corporations fired most of their economic forecasters and planners. Such formal methods had turned out to be mostly disastrous in practice. It made it more likely that people would ignore crucial new data, not less.
In fact, smarter central bankers tend to acknowledge the limits of projections. As they see it, the real value of projections is a matter of imposing consistency on the central banks outlook, rather than being able to confidently predict the future. It is a way of adding up the current data from different sectors of the economy to produce a unified picture.
But that could be done by simply using outside commercial forecasts, or international forecasts by bodies like the IMF or OECD. Central bank forecasts often perform very slightly better than individual outside forecasts, but hardly commensurate with the staff resources and attention devoted to them. Averaging different forecasts is usually more accurate than any single forecast in any case.
Central banks shouldn’t be banned from looking at outside forecasts. They should just be forced to pay much less attention to forecasting and projections in general.
In any case, consistency is overrated in practice. Setting interest rates is not like proving a mathematical theorem. Imposing consistency is often a way to ignore trade-offs or puzzles or genuine disagreement.
Forecasts are often more of a distraction than an aid. Central banks actually tend to make decisions in a very different way in practice, as Lindblom argued decades ago. They mostly make successive limited comparisons, because in practice it is too hard and unreliable to do anything else. No central bank makes decisions in an automatic way based on the forecast or a policy rule alone. They get into trouble when they rely on their consistent models too much, and think too little about the flaws or unexpected developments. In other words, using elaborate forecasts is a sign of ineptitude, not practical skill.
That also means markets misunderstand practical central bank policy when they think the models are as important as the staff economists who produce claim, or trust the official accounts of all the meetings that go into the forecast round. As often happens, the way things happen is often different to the version in the official description or organization chart, and often even different to what people tell themselves they are doing.
If you can’t reliably predict, you need ways to control your exposure and adapt. “First, do no harm” is the best rule for monetary policy, not elaborate technical theater.
People should learn from their mistakes, or so we usually all agree. Yet that mostly doesn’t happen. Instead, we get disturbing “serenity” and denial, and we had a prime example of it this week. So it is crucial we develop ways to make learning from mistakes more likely. I’d ban forecasts altogether in central banks if it would make officials pay more attention to what surprises them.
The most powerful institutions in the world economy can’t predict very well. But at least they could learn to adjust to the unexpected.
The Governor of the Bank of England, Mark Carney, testified before Parliament this week to skeptical MPs. The Bank, along with the IMF, Treasury, and other economists, predicted near-disaster if the UK voted for Brexit. So far, however, the UK economy is surprising everyone with its resilience.
So did Carney make a mistake? According to the Telegraph,
If Brexiteers on the Commons Treasury Committee were hoping for some kind of repentance, or at least a show of humility, they were to be sorely disappointed. Mr Carney was having none of it. At no stage had the Bank overstepped the mark or issued unduly alarmist warnings about the consequences of leaving, he insisted. He was “absolutely serene” about it all.
This is manifestly false and it did not go down well, at least with that particular opinion writer.
Arrogant denial is, I suppose, part of the central banker’s stock in trade. If a central bank admits to mistakes, then its authority and mystique is diminished accordingly.
I usually have a lot of regard for Carney, and worked at the Bank of England in the 1990s. But this response makes no sense. Central banking likes to think of itself as a technical trade, with dynamic stochastic general equilibrium models and optimum control theories. Yet the core of it has increasingly come down to judging subjective qualities like credibility, confidence, and expectations.
Economic techniques are really no use at all for this. Credibility is not a technical matter of commitment, time consistency and determination, as economists often think since Kydland & Prescott. It is much more a matter of whether people consider you are aware of the situation and can balance things appropriately, not bind yourself irrevocably to a preexisting strategy or deny mistakes. It is as much a matter of character and honesty as persistence.
The most frequent question hedge funds used to ask me about the Fed or other central banks was “do they see x?” What happens if you are surprised? Will you ignore or deny it and make a huge mistake? Markets want to know that central banks are alert, not stuck in a rut. They want to know if officials are actively testing their views, not pretending to be omniscient. People want to know that officials aren’t too wrapped up in a model or theory or hiding under their desks instead of engaging with the real world.
It might seem as if denial is a good idea, at least in the short term. But it is the single most durable and deadly mistake in policymaking over the centuries. The great historian Barbara Tuchman called it “wooden-headedness,” or persistence in error.
The Bank of England, like other monetary authorities, issues copious Inflation Reports and projections and assessments. But it’s what they don’t know, or where they are most likely to miss something, which is most important. Perhaps the British press is being too harsh on Carney. Yet central banks across the world have hardly distinguished themselves in the last decade.
We need far fewer predictions in public policy, and far more examination of existing policy and how to adjust it in response to feedback. Forget about intentions and forecasts. Tell us what you didn’t expect and didn’t see, and what you’re going to do about it as a result. Instead of feedforward, we need feedback policy, as Herbert Simon suggested about decision-making. We need to adapt, not predict. That means admitting when things don’t turn out the way you expected.
Attention spans are short, particularly in newsrooms. The past is so stale, and outlets need exciting new click bait. So amidst the latest headlines it’s easy to lose track of larger patterns. Remember how worried everyone was back in January about the plunging stock market? It dominated the news agenda and it seemed how nobody could talk about anything else for weeks?
It gets little or no attention (at least from most journalists), but the market has of course come all the way back. The fear has dissipated. The panic that gripped everyone for weeks is gone. For now.
Of course that was statistically more likely, as I said at the time. It takes no great skill to say that: serious 2008-style panics are also very rare. The deeper concern among markets, I suggested, was more likely that policymakers were out of ammunition. But that might not matter so much, either.
So consider this: it’s difficult to argue that the stock market recovery since January has anything to do with policymakers anywhere. No-one saved the day. There was no committee to save the world. The recovery just happened, despite the fact that none of the problems people worried about – a fragile US recovery, slowdown in China, tension in the Middle East – have been resolved. The risks are still there. Perhaps the ECB expanded QE – but there are doubts about its impact even on European bonds. The panic subsided, the media found new breathless urgent stories, people moved on.
The conclusion? Financial markets and the wider economy do have some inherent stabilizing forces, at least in the short run. Not everything has to be planned or controlled by officials and ministers. Control is less necessary than we think. But the more difficult corollary is we have less control than we usually think as well. The economy is a complex dynamic system which is only loosely coupled to our intentions.
There are limited situations where policy input is crucial, most especially bank runs or other liquidity problems. Bagehot laid out the heart of modern central banking in 1873; if you have a panic, lend freely on good collateral. The libertarian claim that markets are always optimal and right is therefore… wrong. Intervention is sometimes needed.
But policymakers are usually not as important as they sometimes like to think, either. We sometimes like to think someone important is in charge and issuing orders (or at least open to blame later) but much of it is just theatrics. Often the most important things are not conscious deliberate choices, but underlying processes and feedback loops. It helps to spot those at work. But it makes for a less vivid, personalized story.
The whole global economy is unravelling, if you believe some recent media claims. But oil and commodity price swings, weaker emerging markets, or even renewed recession worries are not that unusual. In fact, this kind of news is completely normal and routine, as are the the scale of share price falls so far. Even a dip into recession in the US is a very normal occurrence. So why the air of panic?
I suggested in the last post the underlying deeper concern is whether policymakers have any “ammunition” left in the locker. The fear is any setback will feed on itself and turn into a downward spiral. We are already at the zero bound on monetary policy, and we are still suffering a fiscal hangover from the 2008 crash. There are growing doubts among the public across the world about the competence of policymakers, which is also showing up in revolts against “the establishment.” If there is another downturn or any kind of problem, perhaps the policymakers can’t cope.
Let’s focus on economic policy, and leave the political side for later. Are policymakers really out of options if there’s another market slide? The answer is … actually yes, there are few effective policy options left. But the economy isn’t like a simple machine in which you can pull levers anyway. It’s complex, evolutionary and (mostly) resilient. That means looking at the problem in a different way.
Central banks can always find something to do to appear busy or engaged. So we have seen the introduction of negative rates by the Bank of Japan last week, as well as talk of another round of QE by the Fed if recovery falls apart.
There were even rumors going around the other week that the Fed was intervening indirectly to affet the VIX, an index of market volatility, which is likely absurd.
In the end, the Fed could finally hire the helicopters Friedman and Bernanke mused about, and throw hundred dollar bills out the door in a new city every day to stimulate the economy. Would it help?
If a doctor doesn’t know what’s wrong with a patient, there are always things which give the appearance of useful action, from trying random drugs right up to amputating limbs.
The question is whether the unconventional cure works, or perhaps has such severe side effects it makes things worse. You can always try giving an aspirin to cure a heart attack, but it might not help much. If you get too unconventional in economic policy, just like in medicine you can end up in quackery, with snake oils, balsams and elixirs that promise to cure everything – with no actual effect.
And sometimes there is just nothing more even the most advanced medicine can do for a patient, despite the shiniest machines and telegenic doctors dramatically applying the defibrillator and yelling “clear!” They give electric shocks to the patient .. . while watching the screen trace flatline. The same might be true in economic policy if the disease is serious enough.
The reality is the normal tools and cures are mostly played out. At best, the current “unconventional policy” central bank cures are very imperfect substitutes for cutting the main policy rate in a usual downturn. Sure, monetary policy can always increase the quantity of money, or try to push people into riskier assets by making riskless assets like bank balances or short-term bonds less attractive, or inflate away some debt claims. The markets mostly firmly believe that QE boosts the equity market (for a while.)
The problem is transmission from the financial sector to the real economy. Or, as it sometimes called, the old problems of “pushing on a string” or liquidity traps or animal spirits. If there’s no demand for credit then the price of credit is irrelevant. If corporations are retaining profits and more focused on share buybacks than any new borrowing, then they don’t care about bond market conditions.
Also, it is hard to affect longer-term cycles or stock problems by acting on short-term flows. Ray Dalio argues we are at the end of a 70-year credit cycle, for example.
Buying time, not jump-starting the economy
Smarter central bankers know that there’s a limit to what they can do, or at least do effectively. Just like most other economic phenomena, there is diminishing marginal utility to most policy tools. The more realistic thinking behind the scenes is at best they can buy time for other processes to work themselves out, or perhaps offset some of the pain of restructuring and recovery in the real economy. Central bankers can still stop bank runs or Bagehot-styles liquidity panics, but they can’t jump-start a whole economy.
And in any case perhaps, they sometimes think, they are just letting politicians off the hook anyway. Monetary policy just enables the lazy politicians to avoid making tough decisions. For example, fiscal policy – more government spending – would be more effective than simply reducing the cost of money.
The trouble is fiscal policy has definite limits too (although the Paul Krugmans of the world have difficulty recognizing that.) Japan has spent trillions on stimulus and building infrastructure in the last two decades, running its debt to GDP up to more than 245%. There is plenty of concrete to show for it, but not a lot of vitality or growth. Bond markets more generally are potentialy fragile.
So if there are limits to stimulating demand, at some point you have to focus on the health of the real economy itself and the deeper sources of vitality and growth. That is where we need to look. The conventional economic answer here is you need to push through structural reform – more flexible labor markets, deregulation, more efficient tax collection, the usual range of things that the IMF always recommends.
Politicians have not been particularly good at that. Europe is always ducking such structural reform. A thousand initiatives to build “the next Silicon Valley” in Southeast Asia or Northern France or the Gulf States have faltered.
So here’s another thought: perhaps even if the policymakers have no ammunition left, it might not matter so much.
The critical underlying assumption is this: how resilient is the economy anyway? How likely is to fix itself regardless of the policymakers?
Indeed, there is a long-standing and ferocious argument that central bank intervention has usually made things worse. Attempts by the Fed to “fine-tune” the economy have usually led to errors and mistiming and moral hazard. Central banks have a tendency to hit the accelerator just when they should be braking, and vice versa (in retrospect.) The belief in a “Greenspan put” or bank rescues has just made Wall Street reckless and greedy.
Indeed, until the 1930s, economists generally believed in laissez-faire. Intervention could only make things worse, delay adjustment and prolong the pain. Andrew Mellon, Hoover’s Treasury Secretary, notoriously thought pain was necessary to “purge the rottenness in the system.”
Many libertarians still take this view, advocating a return to the gold standard or free banking. (I have got cornered by rich former used car dealers at the Cato Institute in DC arguing precisely that. At length.)
The Keynesian revolution denied all that. Sometimes the economy could get stuck in a much less desirable state or equilibrium and policymakers have to act. And modern electorates flatly will not accept it. As Karl Polanyi argued, the gold standard would be impossible now because voters would revolt.
There is also the “BIS view” that the Fed in particular has overstimulated for two decades in order to avoid confronting the real problems. I’ll look at that another time.
I doubt the economy is inherently stable or that we can put much faith in equilibrium or simple “optimal control” ideas about policy. But the economy is more resilient than we sometimes think.
So the most urgent question, we now see, is what makes economies resilient? And are we in trouble on that basis? Maybe the economy isn’t like a machine where we can easily pull policy levers to make it change course. We’ve been looking for answers in the wrong places. It needs a different kind of thinking about economic policy, which involves complexity and leverage. Next.
So as we all dig ourselves out from the snow on the East Coast, the S&P is sliding again. There’s no sign of hibernation from the bears. In fact, there seems to be an unusual amount of pessimism and angst out there among professional investors, and wider unease among the public which shows up in support for populist or socialist candidates in the Presidential race.
So how much should we worry? Is it time to plunge our head in a snowdrift and hope for the best? Let’s take the positive view first, and then go to the dark side.
So far the stock market slide is nothing out of the ordinary, of course, uncomfortable and morale-deflating as it is. We usually get a 10% correction in equity prices every two years or so, based on the historical record. So far it’s a bear cub, rather than a raging grizzly.
Let’s say it gets worse from here. 20% corrections are more lumpy in when they occur, but the long term average is they hit every 3 1/2 years or so. That’s a definite scrape from the bear, but not life-threatening. And we’re still very far away from that.
50% or more plunges, like 2008, are extremely rare, far out the tail of the probability distribution, occurring every generation. Or two. Or three. But because we have painful memories of the most recent collapse, press stories about “worse than 2008” sell newspapers right now. Everything looks dangerous, but just like major earthquakes or hurricanes, it is likely to be decades before another hits us.
Putting this together, the most likely outcome, just in bare statistical terms, is a kind of regression to the mean and therefore recovery rather than another 2008-style catastrophe. That happens much more often in situations like this than a further slide to doom.
The trouble is frequency statistics can mislead. What if something more fundamental is broken? What if there’s cumulative damage? There are always plenty of “This time it’s different” arguments for potential disaster when markets are weak.
So what is different right now? What is so deep-seated and cumulative it could put us in 50% territory?
The main cause of recent market weakness appears to be the slide in oil prices, as well as concerns about a slowdown in China with knock-on effects on commodity producers. Add to those multiple pressures on emerging markets the recent Fed rate rise, which may have disproportionate impact on the outer fringes of the dollar zone.
Yet oil and commodity price swings are anything but unusual. A decline in oil prices is bad for the energy sector but good for just about everyone else in the major western economies. The same applies to a first Fed rate rise in a cycle, even if it does tend to upset markets.
And it isn’t at all clear yet that China really has had a ‘hard landing’, as opposed to volatility on its equity markets. Many people have lost their shirts predicting collapse in the Chinese economy over the last ten or fifteen years.
There is clearly a massive debt hangover, and massive surplus capacity. Let’s affirm it: China has plenty of problems. But it could be a chronic gradual headache for years, rather than a spectacular meltdown which causes the whole world economy to crash. Or a painful temporary interlude, like the many spectacular crashes as the US nonetheless rose to the pinnacle of the world economy between 1865 and 1914.
The same applies to tension in the Middle East. There is obviously a heightened chance of serious conflict, as low oil prices cut budgets and the Saudis are increasingly fretful about Iranian resurgence. But that too could be a chronic, slow-moving problem rather than an immediate hot war. Sunni-Shia tensions date back to before 680AD, after all. This is not unprecedented or unusual territory. “Trouble in the Middle East” is barely even news these days. And if a ship does get sunk or riots break out in a smaller Gulf state, oil is likely to spike – offsetting other worries.
None of this is likely to derail the US economy. It’s compatible with a rotation in economic activity from emerging markets towards the US, rather than a collapse in the world economy. On this story, the US with its relatively minimal exposure to foreign weakness takes over its usual role as the ‘locomotive’ pulling much of the rest of the world economy. Safe-haven capital flows to the US, interest rates rise as the Fed normalizes, the dollar accordingly rises giving a boost to exporters in other countries, and the locomotive is on its way.
Sure enough, there are some reasons to doubt that it is happening just yet – American consumers may be saving some of the dollars they are not spending at the gas pump, or driving more miles than before. But there is no reason to despair, or disbelieve altogether than the US is not going to gain significant impetus from lower energy prices before long.
There are other reasons many people worry about western economies, most notably rising inequality and technological threats to labor. There may be hidden bubbles after all the monetary liquidity we’ve had washing around. I’ll look at those another time – but there’s no reason to think that markets have suddenly become much more concerned about these explanations since New Year’s Day.
The deeper, different problem
Instead, the most interesting possibility is markets are concerned at a deeper level about what we can call the ammunition argument. Let’s say any of these potential threats materializes. We don’t have to predict which one, or time it to the day. Then what?
The US recovery is still fragile. The EU is beset by problems of its own making. The central banks are already at or extremely near the zero lower bound for conventional policy. Fiscal policy is more constrained by the massive buildup of debt from the last major collapse. There is much more suspicion (especially in the US Congress) about bank rescues or lender-of-last resort functions, including more legal chains on Fed actions in a crisis.
So if something does go wrong – the Fed misjudges the strength of the recovery and raises rates too much, say, a Chinese credit crisis leads to emerging market commodity disasters which cause strains in European banks who have lent too much money to middle-income countries – there is no ammunition in the locker.
If we take out the rifle to defend ourselves agains the charging bear, we’ll just hear a muted empty “click” and the bear’s jaws will close on our throat. Unlike any other potential crisis in the last hundred years, we’re defenseless.
On this argument, no-one can really predict the stock market (or the Middle East). It’s not a matter of predicting specific outcomes. But if anything goes wrong, we’re bear food. Talk to Murphy about his law.
And then? This is the deeper fear. Policymakers can’t do anything. They may stage a few theatrics, write “bang” on a piece of paper and wave it at the bear, perhaps. And whatever they do, they’ll likely mess it up. (They’ll probably misspell “bang”). It’s also linked to wider suspicions that elites don’t know what they’re doing.
This ammunition argument is the really important question, and deserves more consideration in the next post. It’s probably not true, but it’s a serious argument.
There’s near consensus now that the Fed will finally raise rates on December 16th, after it hesitated back in September. It’s the biggest economic decision of the year and will have ripple effects around the globe. What should we look at?
One thing that doesn’t get enough attention is that raising rates means something very different now to the old system centered on the Federal funds rate. Economists often overlook the nitty-gritty of monetary policy implementation, ignoring the pipes and tubes and dials down in the boiler room. That involves getting a bit dirty, and means having to move around real things instead of abstractions.
In fact, making the damn machine work is not easy. Our knowledge of the transmission mechanism, as it’s called, between changes in short-term rates controlled by central banks and wider monetary and economic conditions is surprisingly limited.
Think about this: The Fed still can’t wholly agree just what, if any, impact almost four trillion dollars of QE purchases had, even in retrospect. It appears to have done some good, especially for the stock market, and we have rather vague theories which suggest it might have helped.
In most other areas of life, if you spend four trillion dollars you don’t need fine statistical tests to see the impact.
Moreover, central banks desperately want to find evidence that such unconventional policy measures are still effective even when normal instruments no longer work. The idea of being impotent is anathema, not least because it potentially has damaging consequences for confidence if markets think authorities are powerless. There is a very large amount invested in the image the authorities have things under control. But actual evidence usually reduces to dubious correlations.
At least we’re back to the land of conventional policy now, you might say. We’ll get a standard rate rise this month. But not as we knew it. The familiar structures are ruined or gone or ignored. The Fed has to use new, relatively untested instruments like interest on excess reserves (IoER) and reverse repos, and it is dealing with the effect of its vastly oversized balance sheet.
Of course, it’s had almost six years to think about it, and the NY Fed desk developed an almost endless supply of alphabet soup of new programs and measures during the crisis to make things happen. They are resourceful. They are bound to say they’re confident they’ve got things under control now (because that’s their job to say that.) They’ll have a range or corridor, instead of a point target, and can widen the range if things get dicey. The chances are they’re smart enough to get this right.
But it depends on a lot of things they don’t control, and the last few years has shown that central banks can sometimes make spectacular mistakes. For one thing, all that dollar liquidity anecdotally ended up abroad, often sloshing into emerging markets. It’s impossible to think in terms of a purely US transmission any more. It’s indisputably partially global. It’s possible that there could be a nonlinear pattern in the US, with very little impact on monetary conditions at first, followed by sudden traction at a later date.
For another, the credit system is still a factor. The vast shadow banking system that we had before is effectively dead, and lending standards and credit demand also factor into the net impact. So do sectoral effects: In normal circumstances, some sectors like housing construction are disproportionately interest-rate sensitive and so important to the transmission mechanism. But the housing market may also be particularly affected by its own internal factors for the time being. It’s not quite the same housing market it was before 2007.
The same applies to capital investment. Think about how business investment is changing. Before, a start-up would buy hundreds of thousands of dollars of servers to get their website going. Now they rent space only as needed from Amazon Web Services or another provider. Before long, that adds up to new patterns in how investment responds to credit conditions.
There is also some political risk. At some point Congress is going to wake up to the fact that IoER involves paying banks interest on their reserve holdings for the first time, or, put into populese, diverting public money from the Treasury (and hence deserving disadvantaged groups) into the maw of the evil bankers who caused the crash. Did we mention we’ve got a Presidential election next year?
In response to all this I thought the Fed might hold back in September but take the opportunity to launch technical measures to test the waters, both to signal actual rate rises were coming and to get some essential data on technical implementation. I was wrong about the technical measures, even if they did hold rates. But the technical challenge remains.
Why does this matter? Two reasons. It affects the Fed’s schedule for raising rates, which they have repeatedly promised will be “gradual.” If there turns out to be little sign of reliable transmission, the Fed is going to have to rethink its timing.
Second, there’s always the risk of financial instability in this process. This move has been telegraphed so much for so long that there seems to be little apprehension, at least outside the potential impact on fast money in some emerging markets. But signs of problems may show up first in the micro details of the transmission process – how spreads and risk premia are being affected, and for whom.
So the real thing to watch in the next few months is not the headline Fed IoER rate, but what’s happening a few steps beyond, as the pipes and sprockets and cogs carry the impact far away from the Fed Board room on Constitition Avenue. Watch for signs of steam escaping from unexpected pipes down in the boiler room, not what it says on the dial.
Pricing of a Fed hike has fallen to just 23%, with just under half of economists surveyed sticking with an increase in rates call. I think some officials, especially Dudley, panicked a little during the China volatility, fluffed the message and destabilized market expectations. If the fed hikes now it would be a communication mess.
But the policy case to hike is very strong. Yes, the world economy is still weak and inflation seems very muted. The trouble is policy is still at extremely loose levels.
So I just wonder whether there might be an additional possibility. The Fed is clearly a little anxious about the technical side of rate rises, as the long NYT piece over the weekend showed again. Something which allowed a larger scale “live test” or “demonstration” of some parts of the mechanism might be technically desirable. Turn the key in the ignition even if you don’t formally step on the gas. And that partial, cautious, intermediate kind of step might be an easier way to ease the markets into a rate rise without a tantrum.
One could present technical action as ways to make a promise of a hike at the following meeting more credible, through action rather than just words. One meeting later you could then validate an existing technical or effective rate rise with a change in the more formal “headline” policy setting (after you know it works.) It would, in effect, be both a hold of the official stance and an effective technical hike.
Of course the interest on excess reserves rate is intended to be the new benchmark. But if there is ever a time to blur a rate rise a little and let the New York Fed desk find its feet in the new world, it is now (eg do reverse repos, or even a token asset sale from the portfolio.) For one thing, if they wait longer to hike and then find controlling monetary conditions is harder, or lumpier and more discontinuous than expected, that could be disastrous. They need to callinrate their instruments. And second, the real risk here is not the rate rise itself, but an exaggerated market response to it. For all the proper Fed view that it has to “think of the real economy” rather than market psychology, now is the time to be careful.
So I think some kind of partial action is the sweet spot. If they don’t do that, if it was me I would vote to hold, but with a very strong indication that the following meeting is close to a lock, followed by a few meetings of calm observation. I certainly don’t rule out a hike- they need to get started – but at this stage it would be clumsy.
You’ve probably seen those films about Pompeii that begin with bustling sunlit scenes of normal life, and end with ash clouds and panic and burning and suffocation. The victims had become used to rumbling and smoke from the volcano for decades, and paid no attention to the mountain. Then an epic disaster overtook them and burnt them alive.
Yet people still live on the slopes of volcanoes. They ignore small risks of terrible outcomes , in a consistent pattern called disaster myopia. The slopes are often fertile and attractive. Vesuvius is now surrounded by far more people today than it ever was in Roman times.
In fact, recent discoveries suggest the site of city of Naples itself has been buried under ten feet of ash in the past, in more ancient eruptions far worse than the infamous Roman disaster. The trouble is that evacuating the Naples area would be logistically almost impossible. So Italian authorities largely ignore the possibility.
Disaster myopia also applies to economics and banking and finance, as researchers like Guttentag and Herring have pointed out since the 1980s. People find it very difficult to handle small risks of serious problems, so often ignore them altogether.
That brings us to the events of this week, specifically the massive losses caused by the decision of the Swiss National Bank to abandon their peg against the euro. Only one out of 50 economists surveyed by Bloomberg was expecting a change in the peg – and the one who did expected a tiny move. The Swiss currency leapt 41% after the announcement and ended the day 19% higher. If you measured risk the way so many in the markets do, using standard deviation and value at risk, that should not have happened in the lifetime of the universe. As Matt Levine of Bloomberg View points out,
An 180-standard-deviation daily move should happen once every … hmmm let’s see, Wikipedia gives up after seven standard deviations, but a 7-standard-deviation move should happen about once every 390 billion days, or about once in a billion years. So this should be much less frequent.
Complacency produced the financial equivalent of Pompeii. Losses run into billions of dollars, including major banks, hedge funds, retail fx brokerages, and probably thousands of retail clients who were foolishly trading FX on margin have been wiped out.
That said, it’s one thing to ignore volcanoes which can be expected to erupt every four or five hundred years, or longer. Even if you live on a volcano, you have a very good chance of never seeing an eruption in your lifetime, and in most places you have a good chance of escaping if you do. Events in complex systems like the economy and financial markets are much less predictable. We have, as Keynes pointed out about uncertainty in the 1930s, little or no idea of the odds of many important events.
Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of pivate wealth-owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatsoever. We simply do not know.(QJE, February 1937)
The result, he says, is people fall back on conventional judgment and copy what others are doing. Or, as we see, they use forecasts and “information” sources in much the same way the Romans used sheep entrails to try to foretell the future, despite all the evidence that forecasters almost always miss critical turning points and mostly just produce foolish overconfidence in their clients.
In complex systems formal prediction is usually a futile hope. It is stupid to make decisions on the basis of forecasts that are largely based on extrapolation of historical data and leave conventional assumptions unchallenged. Here’s some things you can do instead:
- figure out what can go wrong with a decision, or position, or point of view. That means examining your assumptions, looking for boundary conditions, and thinking about what-if scenarios. And then develop markers, to monitor events. You’ll never be able to anticipate every eventuality, but you can have enough signals to make sure you are alert, and agile, and suspicious of complacency.
- think about how you and the other side think about the situation. Step back and take a detached view of the game that is being played, and do some “second-level thinking“. I’ve worked in a central bank and have had years of working out how they make decisions from a market perspective. There are ways to do better than the market, largely by avoiding errors most of the market typically makes. I wasn’t following Switzerland so can’t claim I had any special insight here. That said, you can get a much better understanding of how events like this take place by thinking about people’s actual reaction function, not what you think they “ought” to do. Markets and central banks regularly misunderstand each other because they misread communication, misunderstand motivations and have structural incentives to say one thing and do another. Ignoring what people say and concentrating on how they actually think and do is the only way to have a chance of avoiding problems.
- think about where your edge or advantage lies. If you don’t have one, don’t play the game in the first place. What possible advantage could a retail investor have playing FX markets at a leverage of 20 or more? It’s a classic case of trying to pick up pennies just in front of a steamroller. Understanding where your edge actually lies is the first step to using it.
- manage your exposure where you can’t make easy predictions, so that it reflects underlying uncertainty. (This is a point Nicholas Taleb vociferously argues.)
- don’t be naive. Anyone who thinks that the latest soothsayer or prophet is going to help them is naive. Only suckers pay for seers. Financial market companies have wasted billions on futile attempts to forecast the future when they should pay more disciplined attention to the roots of their own views and assumptions. You have to think about the underlying validity of opinions and forecasts, which is usually extremely low.
- have a plan B. If you think about what can go wrong, you can have a plan to deal with it or turn it to your advantage. Instead of making extrapolations from the past, you need to think about how to react to various scenarios in the future.
I’ll come back to some of these in more detail. The most important thing is to develop markers that alert you to problems with your own assumptions. You have to look at mindsets and thinking patterns, not spurious “predictions” and forecasts.
Markets are now expecting the Fed to end QE on schedule, in spite of recent market volatility and faltering foreign economies. I don’t see much reason to dispute that. The Fed wants to be rid of the QE straitjacket, even if it was a good fit last year. It’s better to be less constrained.
There have been some rough, scary days in the bond market recently, to be sure. But the Fed tends to have a “markets go up, markets go down” weary disdain for short-term volatility, at least so long as the mechanics of markets like clearing and settlement are working fine. Less liquidity in junk bonds is not enough to break the US economy, even if it might break some leveraged players with positions the wrong way round.
The central bank also tends to act with a lagged response compared to market players: officials tend to look at the broad average of data since the last meeting, rather than market mood-swings on the latest few days of data.
It would need much larger and more persistent market disruption to alter the Fed’s course. Indeed, you have to expect and even welcome some market upset as the Fed gradually returns to normality. A few market headaches now might reduce market complacency and tendency to bubble behavior. A little bit of two-way risk on Wall St is no bad thing.
That is not to deny the global real economy outlook is getting darker. Weakness in foreign economies is something which needs further monitoring, but the US has plenty of experience with being left as the demand locomotive which is supposed to pull the rest of the world along with it. Just about every US economic official of the postwar period has tried to persuade the Europeans to stoke demand a little more, for example. The Fed will probably want to see firm evidence of foreign weakness actually affecting the US, and is also conscious that falling oil prices will boost the US consumer. A rising US dollar will also boost foreign economies.
So the message will be a perennial Fed line: we will judge the pace of tightening in the light of incoming data, we have no precommitments to any course of action but will respond flexibly to new information.
The market can take the same message in different ways, though , and that’s where the main uncertainty lies. Investors may read that message as a willingness to delay rate rises next year, but there won’t be anything substantially new in it. But of the Fed chooses to reemphasize it has many tools to deal with contingent weakness despite the end of QE3, that might sound dovish to some ears. It’s all the same thing, however.
Could the Fed surprise with an extension of QE? The only reason would be to shock the markets with an additional injection of dovish credibility. But that runs into a “save the ammunition” argument: if there is any chance you may need to respond to a major negative shock later, it makes more sense to keep your powered dry until you can see such a target. So I think it is not the time to spring a major surprise.
Remember that Yellen is not a perpetual dove. It’s just that as long as domestic inflation seems muted or non-existent, she’ll err towards keeping rates low for longer. Look for a revival of the “first rate hike” versus “steepness of rate trajectory” debate before long, though. The longer you leave the first hike, the steeper subsequent rate hikes might have to be – and that could lead to bond market gyrations that make the last few weeks look like child’s play.
One of the greatest minds in twentieth-centry strategy was Thomas Schelling, who won the Nobel Prize for Economics in 2005 for his work on game theory back in the 1950s. Schelling was, however, extremely skeptical about treating strategy as “a branch of mathematics.” According to Lawrence Freedman, Schelling claimed he learned more about strategy from reading ancient Greek history and looking at salesmanship than studying game theory.
So, as often happens, one of the brilliant and creative founders of an abstract approach warned (slightly dimmer) followers against misusing or over applying it.
“One cannot, without empirical evidence,” Schelling observed, “deduce whatever understandings can be perceived in a non-zero-sum game of maneuver any more than one can prove, by purely formal deduction, that a particular joke is bound to be funny .”
Mainstream economics, however, went in a different direction. Now think of what this means for all the economic papers on policy rules and credibility/communication in monetary policy that I referred to in the last post. Most of the problem of central bank communication come from trying to prove by deduction much the same thing as a joke is funny.