Always Late

Photo Credit: Brendan Ross || When policy is late it becomes procyclical. Better to do nothing.

Start with four premises.

1) One of the things everyone acknowledges about monetary policy is that it works with long and variable lags. It’s kind of like dealing with an unmanned space vehicle a long way away. You have to make choices taking into account the lag for the signal to get there, and the lag for the craft to send back data on what is happening. Fortunately with this the length of the lags are known.

2) Another thing that most economists acknowledge is that employment is a trailing indicator of the economy as a whole. Thus employment can misrepresent the strength of the economy. The economy can be strengthening rapidly, and employment has barely budged, or like now, the economy can be weakening and employment can seem really strong.

3) Then there is the Fed’s dual mandate, which means the Fed must try to aim for low consumer price inflation and low labor unemployment.

4) Further confusing matters here is the Phillips Curve, which posits negative correlation between consumer price inflation and labor unemployment. The key assumption of the Phillips Curve is that there is a fixed relationship between wage increases and price inflation. It is dubious that this theory ever worked. If it ever worked, it was during an era when closed economy macroeconomics was a reasonable approximation for how the US economy worked. This might have been true in the 20 years following WWII.

In an open macroeconomy like today, as the US economy strengthens, labor can be sought in many other countries than the US. The key assumption of the Phillips curve is wrong. Whatever modest effects exist are likely accidental and not structural.

I’m no fan of stimulating the economy. If you regulate the banks tightly to keep them solvent, the economy will largely self-correct. Booms and busts will still be there, but not as big.

But that’s not the way our culture views things. They want the government to manage the macroeconomy, even if that management won’t work so well. They want to believe in Oz. (Which, given that Oz was about the so-called failure of the gold standard, this has come full circle.)

Here’s how Oz can function better. The Fed can focus on GDP rather than employment, arguing that by focusing on GDP employment will follow for the most part — and that where it doesn’t follow so well, tell the truth that the Fed doesn’t have much influence over employment.

The opposite of this argument is like this article in the Wall Street Journal, where it says:

Referring to the latest Fed two meetings, Ms. George said, “with moderate growth, record-low unemployment and a benign inflation outlook, maintaining an unchanged setting for policy would have been appropriate, in my view.”

Fed’s George: U.S. Economy Is in ‘Good Place’

George is driving through the rearview mirror. GDP looks a little further forward, and the yield curve looks more forward still. The yield curve is a discounting mechanism, and predicts future movements in lending, GDP and employment, in that order.

So long as the controlling members of the Fed say things like “We couldn’t need to loosen, the economy or employment is strong,” amid an inverted yield curve, or ” “We couldn’t need to tighten, the economy or employment is weak,” amid a steep yield curve, it will always be late, and exacerbate booms and busts.

The Fed likes to trumpet its independence, but more than fearing Trump or Congress, they fear public opinion, and don’t want to take right moves that have bad optics. They would rather get there late, and pretend that the heroes have arrived on time. Going back to Oz, the Fed is a mishmash of the scarecrow and the lion.

Summary

My solution is that the Fed should look at forward-looking indicators, and educate the press and public about what they are doing. If they do that, policy will work better until the forward looking indicators lose their value. Oh well… search for new ones.

Postlude

I know some people tire of my musings on Central Banking. Personally, I hope this is my last post on it for a long time.