Fed Theoreticians Need Some Real-World Feedback: Caroline BaumCaroline Baum
Nov. 11 (Bloomberg) -- If there’s a fire in the building, exit via the stairwell. If the power goes out, wait for the backup generator to kick in. If the car engine overheats on the highway, pull over and call AAA.
These are all contingency plans. Now the Federal Reserve wants one of its own. Instead of merely pledging to hold short-term rates near zero or considering additional asset purchases, the Federal Open Market Committee should provide “a public contingency plan -- that is, provide clear guidance on how it will respond to a variety of relevant scenarios,” Narayana Kocherlakota, president of the Minneapolis Fed, said Tuesday in a speech to the South Dakota Chamber of Commerce.
Call it an “if this, then that” scenario for the monetary set. What sort of academic theory will they conjure up next?
Kocherlakota, along with the Philadelphia Fed’s Charles Plosser and Dallas’s Richard Fisher, dissented from the FOMC statements released at the conclusion of the Aug. 9 and Sept. 20-21 meetings. In August, the three renegades wanted to retain the “extended period” language for the near-zero funds rate rather than introduce a specific time frame of at least two years.
The following month, the trio opposed the decision to extend the maturity of the Fed’s Treasuries portfolio by buying $400 billion of long-term notes and bonds and selling an equivalent amount of short-term securities.
Good for them, saying no to what amounts to rearranging the deck chairs. It’s time to stop playing games. The Fed has one tool, and a powerful one at that: a printing press. Everything else is window dressing.
Less Is More
Sure, a promise to keep the benchmark rate near zero for two or three years will anchor short-term market rates and exert a downward pull on long rates. But the minute the financial markets get whiff of a pickup in economic growth or inflation, those promises won’t be worth the paper they are written on.
It makes me yearn for the days when some things were left unsaid. If the Fed really wants to get a bang for its buck -- even though the marginal cost of producing money is zero -- how about a little surprise? Imagine if the Fed showed up one day and announced it was buying $400 billion of Treasury notes and bonds ASAP. Guess what would happen to long-term rates?
To some extent, the Fed already has a contingency plan embedded in its dual mandate: stable prices and full employment. Last year, with inflation expectations anchored and unemployment above 9 percent, the Fed embarked on a second round of quantitative easing. (If this, then that.)
Unemployment (9 percent) and underemployment (16.2 percent) are still unacceptably high. And when the Fed unveiled its forecasts for the next three years on Nov. 2, those projections showed minimal improvement through 2014.
Why, then, isn’t the Fed providing more stimulus now since its inflation outlook is benign, a reporter asked Fed Chairman Ben Bernanke at the Nov. 2 press conference.
Bernanke hemmed and hawed, then said, we’ve done a lot already, we’re prepared to do more, and after all it’s just a forecast.
Which brings us back to Mr. Kocherlakota and his contingency plan. Would the plan be triggered by a forecast change or reality? (I e-mailed his press spokesperson for clarification and didn’t hear back.)
In his speech, Kocherlakota provided an example of what he had in mind: If actual and projected core inflation rose to 3 percent in 2013 while the unemployment rate fell to 8 percent to 8.5 percent, “a public contingency plan would allow the public to know what the Committee intends to do in that eventuality,” he said.
And then what? The public would decide to buy new computers for the office? Replace the storm windows? Renovate the basement?
What if that 3 percent/8 percent-8.5 percent forecast is superimposed on a backdrop of chaotic financial markets versus a period of stability? Who knows what exogenous events could come into play.
Those Unknown Unknowns
If the Fed’s contingency plan is based on a forecast, we’re in trouble. This is the same Fed that was fighting phantom deflation in 2003, didn’t foresee the depth or the breadth of the subprime crisis, failed to identify the undercapitalized banks it regulates, and downgrades its forecast with every backward-looking revision to gross domestic product. The idea doesn’t instill much confidence.
If, on the other hand, it’s real economic performance that triggers said contingency plan, we’re in even bigger trouble. Monetary policy works, as they say, with long and variable lags. Today’s actions have an impact six to 18 months out.
In an Aug. 11 Bloomberg News profile of Kocherlakota, Nobel laureate Robert Lucas called him “the best abstract theorist ever to head a Federal Reserve bank.”
He may well be, but Kocherlakota and his Fed colleagues need to step outside their ivory tower once in a while and mix with the public, the man on the street, whose expectations they claim to want to mold.
I did just that several years back. Motivated by the Fed’s obsession with inflation expectations, I created and conducted an informal survey. People’s perceptions of current inflation were all over the lot, and their expectations of future inflation were moored to another planet. Fed officials talk and act as if the public has perfect information and behaves accordingly. In the real world, that isn’t the case.
Maybe those theoreticians need to make room for the public at the boardroom table. That way, Fed policy makers would understand how people behave in the real world, not in their econometric models.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)
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