In years past of following economics blogs, I couldn’t help but pick up on the ambient suggestion that models constructed from too many assumptions are likely to suffer from what could be called the Unicorn Syndrome. Of course, for average people, a clarifying statement might be, “If you can’t dazzle ‘em with your brilliance, baffle ‘em with bullsh….”
This is what came to mind as I was pointed to this transcription of a testimony to the House Financial Services Committee given by Marvin Goodfriend, a former Richmond Fed official, now at Carnegie Mellon, and potential Trump nominee to the Federal Reserve Board of Governors, because it is a testimony that did more to confuse rather than enlighten. Here’s an excerpt:
The Fed targets the federal funds rate in order to stabilize inflation and employment as best it can. Output and inflation, however, do not respond directly to the overnight federal funds rate, but only to longer-term rates. Hence, the Fed targets the federal funds rate with the aim of influencing longer-term interest rates. It exercises its influence as follows. The federal funds rate controls the level of other short-term interest rates in the economy via a variety of banking and money market arbitrage opportunities. The market then determines longer-term interest rates as the average expected level of short-term interest rates over the relevant horizon (abstracting from a time varying term premium and default risk)…
The Fed manages its federal funds rate target to maximize the influence of target changes on longer-term interest rates, and thereby on the economy. To do so, the Fed waits before changing the federal funds rate target until it is relatively sure that it will not have to reverse field any time soon, and that further changes in the same direction are likely. Markets, in turn, understand that the Fed’s interest rate target changes are “highly persistent and seldom quickly reversed.” In this way, a change in the overnight federal funds rate target carries expected future short-term rates and longer-term rates with it as well. The Fed’s inclination to delay federal funds rate target changes explains why monetary policy has been “behind the curve” more often than not in the past, whether acting against rising inflation or looming recession.
Goodfriend makes it plain that the having the public understand the Fed is the key to having a credible inflation target, and rips apart recent Fed statements for lack of clarity which seems a bit hypocritical because very few of “the public” have a quantum computer available to calibrate even the summary of voodoo models written in Greek. But we should feel reassured because later on in the testimony, Goodfriend concedes that the Taylor rule is a reasonable compromise, and we can wait until later to worry about the quantum computer to be sure that whatever sort of model he might be constructing to hit the inflation target is accurate.
To be fair to Goodfriend, we at least see eye-to-eye on the point, in its broadest terms, that the Fed needs a rules-based approach to monetary policy. But if he were to make it to the BoG, I would be gravely concerned about what rule might be adopted given that his testimony reveals that he has , at very least, the gift of bafflement, and his speeches require a rather tall pair of hip boots to match. And this is an important point because it isn’t only credibility of the institution that is at issue here, it is credibility of the individuals in it that is important, and I am instantly skeptical of a person who can’t seem to speak plain English to an audience that requires it.
Later, Goodfriend discusses the damage the Fed wrought on public saving habits during the Great Inflation:
If in years past the Fed had been fully committed to price stability as embodied in an inflation target, retirees would be in a much better position today. Years ago, households would have been advised and willing to hold a significant share of their lifetime savings in long-term nominal bonds paying a safe nominal rate of interest. Households could have counted upon the fact that the nominal return would have been locked in purchasing power terms. The promised nominal interest rate, having incorporated a 2% inflation premium to offset the steadily depreciating purchasing power of money at the Fed’s inflation target, would have delivered a safe long-term real return upwards of 3% per annum.
Instead, the Great Inflation called the Fed’s commitment to price stability into question as it decimated the real return on long term nominal bonds. Responsible households have since steered away from saving in long-term nominal bonds to protect themselves from inflation risk. To avoid inflation risk, households have shortened the maturity of their interest-earning savings and reached for more return in equity products, forced to accept the risk of ultra-low short-term interest rates and volatile equity prices in the bargain.
Interesting. I feel like I am on Mars because even a decade ago, I’d fire any financial adviser who told me to plow my money into government bonds. I also wouldn’t take that sort of advice from a zero inflation targeter because the rub here is that the tighter policy becomes, the lower the natural rate goes, and that return vanishes. Not only do the bond holders end up duped, but recent experiences with the ZLB raises doubts about the soundness of the aforementioned tactic to target rates in order stabilize inflation, employment and the economy. Man, trying to have one’s cake and eat it too just doesn’t work.
Since I learned that Goodfriend is on the Donald’s short list of BoG nominees, I have truly regained my religion, and I pray every night that it just isn’t so.