Tuesday , July 23 2019
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What’s the problem?

Summary:
The problem isn’t the recent decline in equity prices; the stock market tends to be more volatile than the underlying economy.  Nor is it the recent increase in the fed funds rates (2.4% isn’t very high in an economy growing at 5.5% in nominal terms.)  Rather, the problem is two-fold: 1. Unrealistic forward guidance, which ignores market forecasts. 2. Too much inertia in adjustments in the fed funds rate. Elsewhere I’ve argued that the second factor may explain the strange absence of mini-recessions in postwar US history.  And this absence is really, really strange.  Just imagine how perplexed geologists would be if the Earth had no small earthquakes, only large ones.  What model could possible explain that? I’ve argued that the sluggishness in the response of interest rates

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The problem isn’t the recent decline in equity prices; the stock market tends to be more volatile than the underlying economy.  Nor is it the recent increase in the fed funds rates (2.4% isn’t very high in an economy growing at 5.5% in nominal terms.)  Rather, the problem is two-fold:

1. Unrealistic forward guidance, which ignores market forecasts.

2. Too much inertia in adjustments in the fed funds rate.

Elsewhere I’ve argued that the second factor may explain the strange absence of mini-recessions in postwar US history.  And this absence is really, really strange.  Just imagine how perplexed geologists would be if the Earth had no small earthquakes, only large ones.  What model could possible explain that? I’ve argued that the sluggishness in the response of interest rates might explain why it is that when we start to slide into a recession we never seem to stop halfway, with the unemployment rate rising by only 0.9 to 2.0 percentage points.

The fed funds rate is currently around 2.4%, and the market forecasts a rate of 2.3% out in July 2020.  That forecast is down sharply in recent months, although still not in recession territory.  Unfortunately, the Fed is forecasting two rate increases next year, and the markets seemed to react poorly to Powell’s attempt to explain this forward guidance.  Even worse, the Fed is often reluctant to change course, because of a perception that it reduces credibility.  Just the opposite is true.  The credibility that matters is the Fed hitting its macro targets, not its interest rate forecasts.

Earlier I suggested the following reform:  Each day, have every FOMC member email their preferred IOR rate, calculated to the nearest basis point.  Set the IOR at the median vote.  Tell the market that the rate will likely follow something close to a random walk, with an increase on one day often followed by a decrease the next.

Looking further ahead, my preference would be to have the Fed entirely cease its targeting of interest rates and let the market determine the appropriate rates.  Instead, the Fed would give the New York open market desk the following instructions:

1.  A range for one year NGDP growth–say 3.5% to 4.5%.

2.  Instructions for the New York Fed to take unlimited short positions on NGDP futures contracts at 4.5% and unlimited long positions at 3.5%.

3.  Instructions to do open market purchases and sales (with Treasury securities) in such a way as to avoid losses in their trading of NGDP futures contracts.

That’s all.  Let the market set interest rates; they are much better able to determine the appropriate fed funds rate.

OK Fed, you’ve got a landing. Now let’s make it “soft”.

PS.  As I contemplate the Fed’s current (flawed) policy regime, I feel sad and blue:

What’s the problem?Tyler Cowen recently linked to an article on the Chinese industry of copying famous oil paintings. This is a detail from an oil painting I purchased in China, for about $15 dollars.  It hangs in my office.  In downtown LA, people spend thousands on paintings by hip new artists.  I can get better art in China for a tiny fraction of the price. You might argue that they aren’t really buying art, they are buying a story.  And “I support hip young artists” is more appealing than “I buy Chinese knockoffs of famous paintings.”  Fortunately, I don’t care what other people think of my taste in art.

Merry Xmas and Happy New Year

PPS.  You want a Christmas theme?  Here’s an even better painting (by Titian), recently restored to its former glory:

What’s the problem?


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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