Monday, November 2, 2015

"Are we tight yet?"

RockyMcNuts at Reddit links to Are We Tight Yet? The Fed's Problem in Finding the Neutral Rate at Bloomberg Business. I like it.

When the topic is cast as We should raise interest rates immediately! or No, we shouldn't! it seems to get a lot of attention. Cast as a discussion of the Fed's difficulty in deciding whether to raise interest rates, and when, it gets very little interest even after 14 hours on Reddit. 

That's part of the problem. Everybody already has an opinion. Everybody thinks they know the answer. Everyone is satisfied with their answer. (And yet, we disagree.)

What I liked about the Bloomberg article was that it focused on not knowing the answer. For me, that opens a door.

From the article:
“The one thing you know is that you don’t know,” said James Hamilton.... “People in the Federal Reserve and everywhere else are trying to figure out: What’s the permanent change, and what’s just the overhang from the episode we’ve been through?”


If the natural rate is well above the current near-zero rate, as Chair Janet Yellen and many of her colleagues suggest, then policy will still be accommodative well after the central bank begins to raise rates, encouraging further investment and hiring.

If the gap is smaller -- or if the natural rate has fallen so much that it’s at or under zero, as some suggest -- the early stages of tightening could restrain the U.S. economy more than Fed officials expect.

“There’s a lot of uncertainty about what the appropriate level is,” said Laura Rosner.... Such discord “is going to heighten the disagreement about what to do with rates.”

Even among economists, evidently, most of them think they know the answer. And, like the rest of us, they disagree with each other. This disagreement apparently leads to uncertainty at the policy level. The article says a new study "emphasized that a lack of conviction 'in turn creates uncertainty about the appropriate level of the short-term interest rate'." Or again:

There’s also disagreement about how the Fed should respond to the uncertainty surrounding the level of the natural rate.

By "how the Fed should respond" they mean "raising the benchmark rate sooner rather than later" or "the opposite." This gives the impression that the lack of consensus is the source of trouble -- that if economists could only manage to agree, then their answer (whatever that answer happened to be) would be the right answer, and the Fed would go with it.

It seems they are saying the neutral interest rate is determined by consensus opinion. I don't buy it.

I think it bizarre that a lack of consensus in the private sector could lead to uncertainty at the Fed. It is as if policy-makers think a policy is wrong if opinion-makers think it is wrong. This is bullshit. Given economic conditions at any point in time, there is one general direction that points to the best choice for policy. This is true, regardless of what anybody thinks.

That's what I think.

Trouble is, policy-makers don't know which is the right direction.

If we define "the neutral rate" as the article does:

"the borrowing cost -- adjusted for inflation -- that keeps the economy at full employment with stable prices"

then I'm not even sure the neutral rate exists. Since the crisis, I mean.

Maybe the loss of our ability to achieve "full employment with stable prices" is the permanent change that James Hamilton was wondering about. ("Permanent" here does not mean "from now till the end of time". It means long-lasting or highly persistent.)

Loss of our ability to achieve "full employment with stable prices" or, say, to achieve full employment, period. If that was the permanent change, then disagreement over the level of interest rates is pointless.

That would explain why the disagreement cannot be resolved: Because both sides are right when they say the other side is wrong. Both sides are wrong, because setting the level of interest rates can no longer get us to full employment. The focus on interest rates is the wrong focus. We need instead to ask why achieving full employment is no longer possible.

See what I'm getting at here? We need to re-think economics. We need to re-think premises. We need to do something smarter and more honest than redefining "full employment" to a higher number (again) or changing who we count as unemployed to get that number down. Again.

We need to re-think the premises. This has been said many times, in many ways, since the crisis. But nothing has changed. We still think we can get back to "full employment with stable prices" by fiddling with interest rates while Rome burns.

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