The Wonks Battle for the Fed
OK, so you work in finance. You’re an asset manager, a bond trader or a financial adviser. You have exposure to broad economic risks. Obviously you want to know how the Federal Reserve makes decisions. The amount I don’t know about the Fed could fill a library the size of the universe, so don’t regard me as a Fed expert (for that, go to Tim Duy). But I do think I may have a little bit of insight about one of the issues behind the Fed’s thinking, so I’ll try to explain.
The Fed, fundamentally, is a bunch of academics. It hires top or near-top job candidates from good economics graduate programs, and the Federal Reserve Banks -- which are really just government-funded research labs, the econ equivalent of Brookhaven or Sandia -- employ top professors part-time or after semiretirement. So the Fed is heavily influenced by academic ideas -- papers, theories, models and empirical studies. Understanding econ academia is important to understanding the Fed. That means wading into the odd, brilliant, dysfunctional culture that is macroeconomics.
Macro is a field in which it is very hard to prove who’s right, so people are forced to rely on their intuition. When the issue is monetary policy, the intuition is naturally going to break down into “people who think monetary policy should stabilize the economy,” and “people who think that’s a bad idea.” Just for fun, let’s call these tribes the “monetarists” and the “anti-monetarists.” Anyway, academia works based on tribes, so these groups will coalesce over time, not into exclusive clubs, but into loose networks of researchers who know each other’s work and only occasionally take a close look at what the other tribe is doing.
The big dust-up between the tribes really came right after the big inflation of the 1970s and early '80s, and flared up intermittently all the way to 2007. That was when the antimonetarist's Real Business Cycle models and the monetarist's New Keynesian models duked it out. If you want to read more about this big shift, and if you’re a colossal nerd like I am, then I recommend the recent string of blog posts by Robert Waldmann, Paul Krugman, Simon Wren-Lewis, and David Glasner. Realize, as you read, that those are all people from the monetarist tribe. The New Classicals they’re talking about are the antimonetarists.
The one-paragraph version of the history is that the New Classicals won the methodological debate -- they got everyone in macroeconomics to use their chosen type of math. But their opponents, the monetarist New Keynesians, ended up having more influence at the Fed. So that epic intellectual battle basically ended in a stalemate.
These days, essentially all of the pre-2008 models have fallen out of favor, replaced by models where finance is the key. Most people would agree that’s a good thing. But those models are going to have just as hard a time getting conclusive support from the data, because there just isn’t much data. So again, conclusions about whether the Fed should print money and buy bonds to fight recessions will come down to intuition. As Waldmann says, “The models change but the policy proposals remain the same.”
This brings us back to the Fed. The Fed doesn’t really know what it can do to boost the real economy, or what the side effects will be, because in order to know that, you would have to know which macro theory was right, and that’s the one thing no one does know. So the quasi-academics at the Fed stand in the middle while the academics of the two tribes push back and forth.
The battle for intellectual influence over the Fed is waged in academia and at the Fed banks themselves. It’s a fundamentally political battle -- not left-right, conservative-liberal, or Republican-Democrat politics, but academic politics. As political scientist Wallace Sayre said, "Academic politics is the most vicious and bitter form of politics, because the stakes are so low." In this case, though, the stakes are high, but nobody knows what they are. Still, the war -- which most macroeconomists will insist is over or never existed, until you get them behind closed doors -- is occasionally as vicious and bitter as anything Sayre predicted.
So as a Fed-watcher, how do you use this to your advantage? Simple: you watch what the people in the different tribes say. As in real politics, you watch the median voters -- the soccer moms and Nascar dads whose preferences sit near the middle of the spectrum. The public votes at the polls, but academics vote by writing papers, so you want to look at the macroeconomists who are not just median, but also at the top of the field. As a prime example, one of the most median of the macro soccer moms is Mike Woodford, who wrote the book on New Keynesian models but who is respected by the anti-monetarist tribe as well. In 2011 and 2012, Woodford released an academic paper and an essay at the Kansas City Fed's Jackson Hole, Wyoming, conference, both of which argued that quantitative easing -- the stimulative monetarist policy conceived by Milton Friedman -- had limitations. If you’re interested in Woodford’s reasoning, you can also check out his recent interview with St. Louis Fed economist David Andolfatto. The basic message is: A little QE is good, a lot of QE is bad -- just the kind of thing that would imply a Fed taper of QE.
Woodford’s ideas might have had an outsized influence on the Fed, or they might have just been a sign of the times -- an intellectual reaction to the failure of seemingly massive QE to have dramatic effects on the economy. Either way, they were probably an early signal of the taper. So for all you Fed watchers out there, you could do worse than to watch Woodford and other prominent “swing voter” economists, to see what the Fed as a whole is thinking.
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