The minutes of the Federal Open Market Committee (FOMC) meeting on December 14 and 15 have been released, and the apparent hawkish trend has at least temporarily caused a daze in sparkling risk markets. From my perspective, there weren’t a lot of surprises in there, but I don’t give too much importance to the micro-Fed watch. No matter what they think they will be doing in December 2021, what they will do in June 2022 depends on the data released by then. This article contains probably obvious comments on the outlook, as well as theoretical rants about the underlying framework.
The comments I have seen focus on the FOMC committee members, apparently in the process of shifting from a more accommodating position. It is hardly surprising. Central banks have the luxury of reacting to the released data, and various inflation measures have continued to surprise the high side.
While I like to take punches against central bankers, I can’t really fault them for this pivot. I’m not a forecaster, but if I had been, I probably would have been wrong about the trajectories of the various inflation measures in the second half of 2021. Although some shortages (and / or opportunistic price hikes from oligopolies) were Predictably, inflation metrics remained more cheerful than I expected. The pandemic has disrupted working methods and certain groups of workers have stronger bargaining power than before.
Looking ahead, the question is to what extent the economy returns to pre-pandemic trends. I’m not quite sure what the vibe is elsewhere, but Quebec has reinstated a curfew and other restrictions (bye-bye curling). Even with a high vaccination rate, life did not return to normal. The Omicron wave may turn off quickly (as it seems to have been in other places), but it still slows down the activity.
Yes for an optimal policy analysis!
The best description of the Fed’s policy process is that they react to historical inflation and growth data, and attempt to manage the sentiments of manic-depressive financial market commentators.
We are far from neoclassical academic conceptions of monetary policy. Central bankers strive for optimal results in a game where they know the effects of policy on the economy. So all obscure assumptions whether they target the average inflation, or whatever.
The problem facing neoclassical macros is that they live in the academic model of publication or destruction. This model does not handle resolved issues well. And if we accept the neoclassical assumptions, monetary policy is a problem solved.
- Neoclassicals assume that raising the policy rate will reduce inflation. This is built into the models, so the empirical analysis simply attempts to find the parameter values ââfor the assumed model.
- Other ways to control inflation – including price controls1 – are not taken into account.
- There is great uncertainty in practice as to the effects of monetary policy, as well as the outlook for the economy. To what extent models have “solved” these problems, they exploded as soon as something broke out of previous trends.
- There is even considerable uncertainty about how to measure key aggregate values, such as âinflationâ.
Control theory offers us a simple answer to this situation: faced with the extreme uncertainty of the model, you have to stick to simple control rules. Raising rates when “inflation” is “too high” (assuming you believe the conventional history of interest rates) is such a simple rule. Any attempt to go beyond that – especially optimization – requires too much certainty in the structure of the model. Optimality conditions are particularly pernicious because they rely on taking an extreme result of a certain model.
However, to admit that the central bank follows such a rule would mean that central bank researchers would have to forgo writing academic papers. Given the institutional incentives, this will not happen. Fortunately for the rest of us, it’s safe to ignore this release, as we know the issue has already been (allegedly) fixed.
The funniest part of the minutes for me was reading how the brains of the Fed struggled with their balance sheet politics.
- They constantly referred to the policy of “normalization” in the minutes. (My quick tally found 26 mentions of “normal” or “normalization” in the text.) I hate to rain down on people’s parades here, but for a 25-year-old trader, the last time the Fed would have had a The normal check-up policy was when they were in elementary school. Having an inflated balance is the ‘new normal’.
- They have no idea what the expansion of the Fed’s balance sheet is doing to the economy. The effect of interest rates on the economy is infinitely clearer to them – and even then, heterodox economists are wondering. At best, big balance sheet proponents end up posting charts of the Fed’s balance sheet against the S&P 500, placing them in the prestigious intellectual company of the Austrians on the Internet. Their own mathematical theories would tell them the effects would be negligible.
- Changing the balance sheet is difficult to do quickly. In fact, probably slower than fiscal policy. And of course, neoclassicals reject the use of fiscal policy as a stabilization tool because it moves slowly.
Either way, given that the Fed’s policy is now to cut rates to zero and then buy tons of bonds every time there is a crisis / recession, readers might as well s ‘get used to this debate.
1 There has been an ongoing debate on the Twitter economy about price controls. I have largely ignored this debate on a very bloody basis: There is no prospect of a political party imposing price controls without something else drastically changing in the economy. I know there are a lot of MMT supporters who are supporters of price controls, but I’m not really on that side. If we need full mobilization of societal resources for a task, of course. But beyond that, if you need to implement price controls to support another policy, you really need to educate yourself about the implementation of that other policy. In the context of the debate in the United States, it appears that enforcing antitrust laws in the spirit of decades ago could solve much of the âprice hikesâ that have arisen.
Editor’s Note: The bullet points for this article were chosen by the editors of Seeking Alpha.