Wednesday, December 28, 2011

Shocking answers

Not long ago, at Asymptosis:

The Fed Always Thinks That Unemployment’s Not a Problem

Their model is obviously telling them that whatever (non-)actions they’re taking at the moment will solve the problem.

And their model is obviously, consistently, and wildly wrong — and always wrong in the same direction.

Altering that model to accurately predict unemployment, of course, would require that they allow more inflation in order to address both of their mandates.

And higher inflation utterly slams the real wealth of creditors.

And the Fed is run by creditors.

From the St. Louis Fed, Working Paper 2011-041A by Richard G. Anderson and Kevin L. Kliesen:

How Does the FOMC Learn About Economic Revolutions?
Evidence from the New Economy Era, 1994-2001

For monetary policymakers, and for business economists, a major challenge is tracking, understanding, and recognizing changes in the economy as they occur. Economists are fond of modeling economies as mathematical systems but some policymakers—former Fed Chairman Alan Greenspan, perhaps most notably—emphasized that model uncertainty causes monetary policy to be an exercise in risk management. In this framework, policymakers seek to learn about the changing economy even while they adopt policies that hedge against large unfortunate outcomes not well captured by the forecasting models.

Asymptosis and Greenspan agree that the models are a problem.

In Greenspan’s view, therefore, policymakers are rarely sure of which probability distribution they are confronting. Thus, the prudent course of action is an application of Bayesian decision making: (i) gather as much information as possible; (ii) quantify the probability of possible outcomes; and, (iii) act aggressively to hedge against potentially catastrophic outcomes (deflation or depression).

So the problem is perhaps not as simple as the Asymptosis post would have us believe.

I still haven't figured out "Bayesian". But the definition of "potentially catastrophic outcomes" is clear. It should be clear also that "hedging" against catastrophe suggests that policymakers have no clue what's wrong with the economy, nor how to fix it.

During the so-called “New Economy Era,” labor productivity (output per hour) played a key role in shaping the Federal Open Market Committee’s (FOMC) response to evolving economic conditions. Indeed, productivity discussions have a long history at FOMC meetings. For instance, unexpectedly strong productivity growth during the early 1980s generated arguments that would become familiar to participants more than a decade later. Questions such as: How much should the Committee risk its price stability goal to gamble that nascent accelerations in productivity will persist? If the Committee were to regard the risk as unacceptable and tighten policy preemptively—as suggested by inflation forecast targeting with models that do not incorporate the positive shock to productivity growth—how much output is lost? And, how does this interact with the FOMC’s dual mandate from the Congress to seek both price stability and maximum sustainable economic growth?

I have an advantage over the Fed. I don't operate in real time, setting policy based on the latest news reports. I just look at the past and evaluate trends.

But sometimes I have to wonder whether the Fed ever looks at the past and evaluates trends. Oh, sure, "unexpectedly strong productivity growth during the early 1980s generated arguments that would become familiar to participants more than a decade later." But more than a decade later the FOMC had progressed only toward greater uncertainty. "Knightian" uncertainty.

I can tell you why they are uncertain: They don't look for answers. They say things like "models that do not incorporate the positive shock to productivity growth" as though by calling it a "shock" all questions are answered. Don't stick your finger in the socket.

"Why, Mommy?"

"Because you'll get a shock."

It is an answer appropriate for children. It is not appropriate for the Federal Reserve.

In this article, we thus examine how monetary policymakers recognized and responded to the productivity acceleration of the 1990s.

The focus on self is not productive. Rather than examine how policymakers recognized and responded, it is necessary to examine the underlying causes of the productivity acceleration of the 1990s.

And as a hint in what direction the analysis should proceed, consider that the Federal Reserve sets monetary policy. The appropriate analysis is the analysis of monetary causes of the productivity acceleration of the 1994-2001 period.

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