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.
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.
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.
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.
The markets are a little worried about this well-written recent piece about Fed Chair Janet Yellen In the New Yorker. This extract (below) in particular is leading some to wonder whether she will be dangerously dovish and overcommitted to fighting unemployment, and will eventually cause a huge inflationary meltdown.
The more constrained Yellen’s world becomes, the more her instinct will be to return to the distilled essence of herself, the unrepentant Keynesian; the pressure to demonstrate hawkish capabilities comes from without, and the Keynesian inclinations from within. “You can’t think about what is happening in the economy constructively, from a policy standpoint, unless you have some theoretical paradigm in mind,” she told me. Alan Blinder told me that, in the mid-nineteen-nineties, when he and Yellen were both Fed governors and felt they might have momentarily pushed Greenspan into a more dovish position, one of them said to the other, “I think we might have just saved five hundred thousand jobs.” He went on, “We felt pretty good about that. . . . Now she can raise her sights—one million jobs. Two million.”
More and more people are getting uneasy about comparisons to the 1970s. Back then, the Fed misjudged slack in the economy, and dealt poorly with the oil shocks. Inflation got embedded and it took the vicious 1980-1982 recession to restore stability. Being lax about inflation eventually caused the worst unemployment in decades. Is the Fed doing the same thing again, adding a few more shots of tequila to the punch at the party just when everyone needs to sober up and get ready to drive home?
I’d draw a different conclusion from some of the color in the article, however, which matches my own impressions of her. She’s “cautious”, “over prepared”, the “reality” person compared to her much more fiercely partisan husband. She doesn’t like to go out on a limb with extreme positions, such as the incident where she didn’t say much during the big Born/Summers confrontation mentioned in the article. She makes a point of trying to summarize other people’s views at meetings.
In other words, she has a definite point of view, but she ISN’T a flaming ideological partisan firebrand. She is temperamentally pragmatic. Her main Keynesian vice is believing a little too much in aggregate demand as the be-all and end-all. But that is self-correcting given signs of inflation. She is emphasizing unemployment right now because she thinks there is essentially no inflation threat.
Journalists can overemphasize the relevance of academic debates to practical policymaking, because conflict makes for a good story. (Instead, it ‘s usually the unexamined assumptions that everyone agrees about about that cause the most trouble.)
In fact, as I noted here, policy is more incremental in practice. It is made by “muddling through” with tiny adjustments every six weeks, not arguing about questions of ultimate theoretical principle in seminar-room style. Consider: The difference in the Committee’s projected “dots” for timing of raising interest rates is not nearly as large as theoretical differences about economic models.
In fact, it’s likely that Yellen will eventually surprise the markets by flipping towards a focus on inflation more dramatically than expected.
The bigger danger – and this is where the hawks on the FOMC have a legitimate point – is that she will be too activist and overconfident, and will unintentionally cause problems by being too ambitious about what policy can achieve.
First do no harm
The New Yorker article discusses how new classical economists came to believe that monetary policy could achieve little if anything at all. Only Plosser has some sympathy for that extreme view in the committee. All the others think that the Fed can contribute significantly to the economy.
But many acknowledge that the Fed can also make serious mistakes – as happened in the 1970s. It quite easy to make the swings and oscillations in the economy even worse. It’s like pushing a kid on a swing. If you give an extra shove when they are at the top of the cycle, you can make the swings even more hair-raising. That produces squeals of delight in children. . but disaster in economic cycles.
The Fed is still giving the largest shove in recorded history to the economy, as QE slowly tapers and nominal interest rates remain at effectively zero, And it is very difficult to get the timing of shoves right. It is typical for economists to be unsure whether the economy has emerged from recession for six months or longer. Data has a habit of getting revised in ways that massively changes the picture of the current economy. Lags are notoriously “long and variable.” For years central bankers has an instinctive distrust of trying to “fine tune” the economy with too much precision as a result.
It’s not the goal of monetary policy, hawk or dove, which is the risk with Yellen. She’s not chained to a dove’s perch. Instead, she’s more likely to be like a humming bird, in frenetic motion. The blur of flapping wings is the risk.
For central bankers, it’s usually better to me like an eagle, hardly twitching a muscle, patiently watching and floating high above the fray below, and then striking at just the right moment.
One thing to note about the Yellen speech yesterday: it really annoyed a lot of Republicans. The Fed chair talked about the problems faced by local Chicago residents: Dorine Poole, Vicki Lira and Jermaine Brownlee. Explaining things in terms of personal stories of named individuals might seem like a good communication idea. She was trying to explain that the Fed’s goal is to help Main St, not just bail out big Wall Street institutions. So putting it in terms of personal experience might seem like a good way to do that.
But Republicans tend to be enraged when people use vivid particular stories to argue for general government intervention, because activists and campaigning journalists have used the rhetorical tactic so often against them.
Does it matter if the GOP is annoyed? It does if they take the Senate in November, as seems likely, and initial primary talk is being dominated by Rand Paul who is very hostile to the Fed. A Fed keeping rates low to help the unemployed might very quickly be seen as a Fed keeping rates low to help the Democrats.
The Fed does not respond to overt political pressure. But it is aware of political context, and the potential for distortion or backlash of the Fed message would be highest in 2015, when a new Republican Senate and the appeal-to-the-base phase of primary season would most likely coincide with the window for the first rate rise.
Most of the way markets think about decisions – in the Fed or in foreign or fiscal policy – is wrong. Why? Because we rely too much on ideas about how decisions ought to be made, instead of looking at the actual behavior of decision-makers.
I was talking last week about how “decision science” evolved after the second world war. In the standard rational-choice approach, you precisely specify your goals, gather all the relevant data, analyze the situation comprehensively, quantify where possible, and calculate the “expected utility” of all the alternative choices open to you. This is the model that still essentially underlies most of the analysis in economics and finance, including the way most people think about the Fed.
In well-defined and demarcated situations, it’s an excellent way to proceed. In fact, I talked about one of the best guides to expected-utlity decisions as the very first post on this blog. Indeed, it’s the way decision-makers tend to present their own approach in public, as it is more legitimate.
But practical decision-makers usually don’t act that way in the real world, for good reasons. Charles Lindblom, a political scientist at Yale, was one of the first people to start disputing the standard rational choice view of decision-making in 1959. His article, “The Science of Muddling Through” is among the most cited in the social sciences , but virtually unknown to many economists.
Real policy problems are much too complex to analyze in an comprehensive, thorough way, says Lindblom. There are too many interconnections. And theory is usually not precise enough to help in most specific situations.
It assumes intellectual capacities and sources of information that men simply do not possess, and it is even more absurd as an approach to policy when the time and money that can be allocated to a policy problem is limited, as is always the case.
Instead, policymakers and administrators tend to choose between specific incremental steps, assess the results, and then choose again. They make successive limited comparisons. Policymakers cannot decide their objectives and preferences wholly in advance, because they know they only ever partially achieve goals. Specific choices carry different trade-offs between different goals all the time. Means and ends are intertwined and depend on actual choices.
So instead of analyzing everything using a “root” approach, building everything from the ground up, real-world policy is made using what he calls the branch method, “continually building out from the present situation, step-by-step and by small degrees.”
Rational-comprehensive policy is much more dependent on heavy theory and vast collection of facts. Incremental policy is instead mostly dependent on recent experience of the practical effects of policy.
Curiously, however, the literatures of decision-making, policy formulation planning and public administration formalize the first approach rather than the second, leaving public administrators who handle complex decisions in the position of practicing what few preach.
That still applies almost fifty years later.
Does it matter in areas that markets care about, like the Fed? In fact, the first and main example in the Lindblom paper is policy to control inflation at the Fed. Of course the Fed moves in small incremental steps of 25bp or 50bp at a time, rather than a fundamental reassessment of the level of policy.
Step back and think of the implications of this. How much debate has been expended in financial markets on the Fed’s objectives , or the merits of targeting particular levels of unemployment, or the advantages of targeting nominal GDP instead of PCE inflation? How often do financial markets whipsaw based on details of Fed forecasts? This incremental approach says that debate is mostly a mistake because objectives depend on context and comparison of incremental options.
In actual fact, Fed policymaking is in practice much more incremental than rational-comprehensive, despite appearances of the forecast round and formal statement of objectives and disputes between doves and hawks over rational expectations and sticky prices.
It’s not to say the theoretical disputes are irrelevant, or that staffers who produce the forecasts do not think the projections are essential and important. They do matter, especially at pivotal moments and in determining what policymakers expect to see and find surprising. But incrementalism is a much better guide to how the FOMC voters usually behave.
And it is also one more explanation why markets so regularly fail to understand Fed communication and Fed policy. Economic theory is not actually as important as many believe, partly because it so often gives little reliable guide to policy. Instead, it’s a matter of choosing between successive limited adjustments, making trade-offs as you go. Do we raise rates this meeting, or wait another six weeks for more data? Will we have more evidence of recovery or revisions in the data? Is there evidence that previous policy choices are working, or insufficient?
There’s nothing like a soaring equity market to put a spring in people’s step in Manhattan. Here we are with a record high on the S&P 500, the unemployment rate sinking rapidly, and the economy is only 2% off a full-employment level at most. And the Fed is still loosening policy, so long as it is still buying additional bonds, seven years after the first signs of crisis in 2007. Tapering only means it is buying less slowly.
Not everyone follows seemingly arcane monetary policy. So think of the current situation like this. It is like driving along a dark and winding country road with your lights blown out, knowing that there is a corner ahead – but keeping your foot jammed to the accelerator as the needle passes 100 mph. It could make for an uncomfortable ride ahead. The Fed is steering the whole world economy, and people could get flung around.
I’ve been writing about this a little more formally in reports recently. The gist is the risks are still asymmetric: the current level of policy is much more sensitive to downside tail risks of renewed recession and deflation than upside risks of inflation. To continue the bad metaphor, the Fed has only been driving this fast because it was trying to outrun an even worse disaster, like a stereotypical Hollywood car chase. That is still the most important influence on policy.
But once the OJ-style car chase phase is over, the driver will suddenly remember he is going much too fast for normal road conditions. Fasten your seatbelt for sudden lurches.
So the labor numbers yesterday were not catastrophic enough to cause a short-term shift in Fed tapering. But the outcome is mediocre enough to have the Fed feeling uneasy, and hoping it’s mainly noisy data. Added to that, there is a short-term inertia in policy, and officials will be reluctant to take QE off its glide path to elimination without good reason, as open-ended QE has proved such a headache. And other data will hopefully give a more positive indication in coming weeks.
However, any further evidence recovery is faltering would make a flip in Fed stance more likely than the market thinks. “A stitch in time saves nine” will be the frame.