Mar

18

A thoughtful Spec asked me off-list:

How do the wise heads at the Fed know the difference between a 'good' price increase - an appropriate market response to increased demand and/or decreased supply - and a bad one, i.e., one that is a sign of 'inflation?'

The answer in polite Fed circles would be something like:

We know that energy prices are very volatile, so we're confident we can ignore shocks whose demand origins are transient, like weather. The same goes for supply shocks to food production.

Energy shocks driven by real supply disruptions like war are likely to be longer-lived and thus more prone to feed through into folks' plans and price structures. But, by watching non-energy price data, we can learn if this is just a move in relative prices or if it is feeding through to a general rise in all prices.

The former we don't care about. The latter would be a cause for concern and trigger the process of starting to plan for a credit tightening. Perhaps the most important non-energy price we watch in this regard is wages, hence our obsession with public expectations and perceptions of inflation.

The answer for Specs is:

The Fed's rhetoric and symbolism foreshadow its actions, and must be monitored to assess their forecasting bias, and hence the likely trajectory of short-term US interest rates.

The answer for cynics is:

Obviously this is all a scam. Mushrooming economic complexity plus globalization plus the spread of arbitrary government diktats, all atop a fluctuating sea of fiat currencies, make a useful calculation of purchasing power as fanciful as Ponce de León's quest for the fountain of youth.

Public media organs continue to portray the Fed as clever and well-meaning, routinely reminding us that Constitution Ave. guided the economy through the calamities of Black Monday, LTCM, 9/11, etc.

If public faith in the currency (inflation expectations) is managed well, the game can continue. The Fed, Argus-like, does monitor every conceivable indicator to see if stability is threatened.

The good inflation/bad inflation line is simply one rhetorical tool that allows the Fed wiggle room in its pronouncements as it figures out what to do and say to keep things under control.

From Alston Mabry:

From the St Louis Fed:

Monetary Policy, Judgment and Near-Rational Exuberance, by James Bullard, George W. Evans, and Seppo Honkapohja.

We study how the use of judgment or "add-factors" in macroeconomic forecasting may disturb the set of equilibrium outcomes when agents learn using recursive methods. We examine the possibility of a new phenomenon, which we call exuberance equilibria, in the New Keynesian monetary policy framework. Inclusion of judgment in forecasts can lead to self-fulfilling fluctuations in a subset of the determinacy region. We study how policymakers can minimize the risk of exuberance equilibria.

And the companion paper: A Model of Near-Rational Exuberance

We wish to think of the news or add-factor that modifies the forecast as a qualitative, unique, commonly understood economy-wide variable. An example of a judgmental adjustment is suggested by Reifschneider, et al. (1997), when they discuss the "financial headwinds" that were thought to be inhibiting U.S. economic growth in the early to mid-1990s. As they discuss, the headwinds add-factor was used to adjust forecasts over a period of many quarters. Federal Reserve Chairman Alan Greenspan communicated it to the public prominently in speeches. It was thus widely understood throughout the economy and was highly serially correlated. This is the type of variable we have in mind, although by no means would we wish to restrict attention to this particular example. Other examples might include the Y2K millennium bug, or the 9/11 terrorist attacks in the U.S., as well as a host of more minor events thought to influence economic performance. We think add-factoring is occurring continuously.


Comments

Name

Email

Website

Speak your mind

Archives

Resources & Links

Search