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Thursday, September 17, 2015

Transparency Is Not Working - Bring Back Opacity

The Fed did not hike at today's meeting, and it is unclear whether policymakers will follow through on their repeated threat to hike rates "in 2015." In my mind, this is embarrassing. The Fed should go back to their pre-1990s policy of saying practically nothing. (Although they should announce the level of the policy rate; it was silly to have to guess what it is.) In other words, the a Fed announcement would consist of one short sentence. Their forward guidance is hapless; if they say little, they may be able to develop a reputation for inscrutability rather than what they've got now.

In September 2013, I summarised the outlook for monetary policy in the United States in the article: Fed Outlook: Battling Straight Lines. I laid out the cross-currents in the economy, which largely revolved around the interpretation of the fall in the unemployment rate. Is it legitimate, or was it just an artefact of the weakness of labour market (the participation rate falling since there are few jobs)?

I did not take a particular side in the debate (although I hinted I was on the doveish side). I am willing to admit that there is considerable uncertainty about my views. Moreover, I prefer to take a fairly neutral stance since I do not want to end up explaining away everything that conflicts with my view. There is a lot of research already available that follows that methodology elsewhere.

However, the Fed has little excuse. We are in 2015, not 2013*, and there are hundreds (?) of Ph.D. economists working at the Fed, versus the one control systems Ph.D. that is on staff at BondEconomics.com. Estimation of the "spare capacity" in the economy (or the output gap) is the key problem facing central banks. (At least if they follow conventional analysis techniques, which all modern central banks do.) If they cannot do it, all of modern mainstream macroeconomics is entirely useless, as it entirely revolves around a central bank reacting to the trends in the output gap in a forward-looking manner. We might as well go back to models using adaptive expectations, since the central bank is acting in a backwards-looking manner in practice.

Since there is no reason to expect inflation to rise any time soon, I see no justification for a rate hike. That said, there is a strong argument for the Fed to hike rates at least a couple of times, so that we can get away from the inanity of a 0% policy rate.

Bring Back Eighths?

I have seen some chatter suggesting the possibility of rate hikes in 1/8 of a point increments (0.125%). I had a feeling that such a step might be possible, as it would allow for a more gradual rate hike path (100 basis points per year). However, such a step would probably be another public relations problem, as most commentators would find it ridiculous that the central bank is distinguishing such tiny increments in interest rates. Furthermore, it may be problematic as the Fed may have a harder time controlling the Fed Funds rate in an environment with excess reserves. Since the market rate will be bumping around within a corridor 25 basis points wide, a 12.5 basis point move in the target rate looks somewhat meaningless.

Footnote:

* In fact, the trends I outlined then were obvious earlier. However, nothing I wrote before 2013 is in the public domain, so I stick with 2013.
(c) Brian Romanchuk 2015

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