Macroeconomic theory is not the best analystical framework for making monetary policy decisions!

As reported by the WSJ:

A rare sociological analysis of Federal Reserve policy confirms what many economists already knew: top central bank officials missed the oncoming crisis because they failed to make the connection between housing, the banking industry and the economy.

However, the paper’s authors, three sociologists at the University of California, Berkeley, say the problem runs much deeper, and has to do with the narrow framework for analysis—grounded in macroeconomics—that dominates Fed discussions.

Using statistical word analysis techniques to pour through Fed meeting transcripts, which are released with a five-year lag, Neil Fligstein and his colleagues concluded that because of the preconceptions of policy makers and the Fed’s own institutional rigidities, officials tended to underplay economic weakness. “The Fed’s main analytic framework for making sense of the economy, macroeconomic theory, made it difficult for them to connect the disparate events that comprised the financial crisis into a coherent whole,” the authors say.

In the authors’ words:

In sum, the FOMC continued to systematically underappreciate the depth of the crisis through the end of 2007, even after they had begun to identify it as a financial crisis. In this regard they were not alone. The more important point is that their inability to make sense of this crisis seems to have stemmed directly from the cognitive limitations of a conceptual apparatus founded firstly in the training of macroeconomists and secondly in the routines of career central banking. This framework led them to see problems in the housing sector as consequential only insofar as they spilled over to other sectors of the real economy. And it meant that they consistently underestimated the possibility of the financial sector meltdown that would ultimately take the entire economy with it.

Interestingly, more than 20 years ago, during the December 1992 FOMC meeting, a discussion of NGDP targeting ensued. Two points of great interest. At the start of the discussion St Louis Fed president Jerry Jordan says (transcripts, pages 24-27):

MR. JORDAN. This question of when the time is going to come to change the [funds] rate–especially in an upward direction–and the criteria for doing so has been on my mind a lot, and I’m sure it has been in everybody’s thinking. This is my seventh meeting, and I thought it was time to go back and review the last year and to look at what actually has happened in terms of all kinds of economic indicators–monetary as well as economic indicators, nominal and real indicators–and Committee actions to see if I could deduce an implicit model. I read the newsletters, as I’m sure everybody does; and [unintelligible] and I don’t see it in the numbers, it’s certainly not inflation. It’s not the various money measures: Ml, M2, the base, or bank reserves. I don’t even think it’s real GDP. I put together a table–a big matrix of every forecast for as many quarters out as the Greenbook does it–for every meeting for the last year. What struck me was that it looked as if we were on a de facto nominal GNP target. When nominal GNP is at or above expectations, the funds rate is held stable; but when nominal GNP comes in below what has been expected, we cut the funds rate.

Governor Parry sums-up the discussion thus:

I’m afraid a lot of the academic literature would suggest that we probably would reduce the chance of making the kinds of mistakes that we make with interest rate targeting if we followed a nominal income target”.

How prescient he was!

Coming back to the present: The problem was not, as the authors´ argue, that “the FOMC continued to systematically underappreciate the depth of the crisis through the end of 2007, even after they had begun to identify it as a financial crisis.” Where the FOMC erred was to underappreciate the importance of nominal stability, thus allowing nominal spending to crash! The magnitude of the financial crisis was directly derived from the nominal instability the Fed, through its quixotic pursuit of NO inflation, imparted on the economic system.

Would the counterfactual represented by the dashed lines in the charts below result in a very different outcome? I most surely think it would.

Continue reading at Historinhas.

About the Author

Marcus Nunes
João Marcus Marinho Nunes is a partner of Phynance Estratégias Quantitativas e Investimentos and a professor of Economics at Fundação Getúlio Vargas in São Paulo, Brazil. He also blogs here:

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