Fed December Meeting Minutes

The minutes for the December 14-15 Federal Open Market Committee (FOMC) meeting were released, and the apparent hawkishness has at least temporarily caused a tizzy in frothy risk markets. From my perspective, there was not a lot of surprises in there, but I do not put a whole lot of value on micro-Fed watching. No matter what they thought they will do in December 2021, what they will do in June 2022 depends upon the data released between now and then. This article has some probably obvious comments on the outlook, as well as some theoretical rants about the underlying framework.

Hawkish Flip

The comments I have seen focus on the FOMC committee members apparently flipping from a more dovish stance. This is not exactly surprising. Central banks have the luxury to react to released data, and various inflation measures continued to surprise to the high side.

Although I enjoy taking potshots at central bankers, I cannot exactly fault them for this pivot. I am not a forecaster, but if I were, I probably would have been wrong about the paths of various inflation measures in the second half of 2021. Although some shortages (and/or opportunistic price gouging by oligopolies) were predictable, wage inflation measures remained perkier than I would have expected. The pandemic has disrupted the patterns of working, and some groups of workers have stronger bargaining power than before.

The moment you realize 2022 is pronounced "2020 too" 🙀 pic.twitter.com/ffkbsD7eP8

— Cole & Marmalade (@ColeTheBlackCat) January 5, 2022

Looking forward, the question is the extent to which the economy reverts to pre-pandemic trends. The embedded tweet did a good job of capturing my mood. I am not entirely sure what the mood is like elsewhere, but Quebec has re-instituted a curfew and other restrictions (bye-bye curling). Even with a high vaccination rate, life is not back to normal. It may be that the Omicron wave burns out quickly (as seems to have been the case in other locales), but that still sets back activity.

Yay for Optimal Policy Analysis!

The best description of the Fed policy process is that they are reacting to historical inflation and growth data, and attempting to manage the feelings of manic-depressive financial market commentators.

This is miles away from neoclassical academic conceptions of monetary policy. Central bankers are striving towards optimal outcomes in a game where they know the effects of policy upon the economy. Thus, all the arcane postulations whether they to target the average of inflation, or whatever.

The problem that neoclassical macro faces is that they live within the publish-or-perish model of academia. That model does not deal well with solved problems. And if we accept neoclassical assumptions, monetary policy is a solved problem.

• Neoclassicals assume that raising the policy rate will lower inflation. This is embedded in models, and so empirical analysis is just attempting to find parameter values for the assumed model.
• Other means of controlling inflation — including price controls1 — are not considered.
• There is considerable uncertainty in practice about the effects of monetary policy, as well as forecasting the economy. To what extent that models “solved” these problems, they blew up as soon as anything left previous trends.
• There is even considerable uncertainty about how to measure key aggregate values, like “inflation.”

Control theory offers us a straightforward answer to this situation: in the face of extreme model uncertainty, you need to stick to simple control rules. Hiking rates when “inflation” is “too high” (assuming you believe the conventional story about interest rates) is such a simple rule. Any attempt to step beyond that — particularly optimisation — requires too much certainty in the model structure. Optimality conditions are particularly pernicious since they rely on taking an extreme outcome of a certain model.

However, admitting that the central bank follows such a rule would mean that central bank researchers would have to give up on writing theory papers. Given the institutional incentives, that will not happen. Luckily for the rest of us, it is safe to ignore that output, since we know that the problem was (allegedly) solved already.

Quantitative Tightening

The funniest part of the minutes for me was reading how the brain trust at the Fed struggled with their balance sheet policy.

• They continuously referred to “normalizing” policy in the minutes. (My quick count found 26 mentions of “normal” or “normalizing” in the text.) I hate to rain on people’s parades, here, but for a 25 year old trader, the last time the Fed would have had a “normal” balance sheet policy was when they were in elementary school. Having a bloated balance is the “new normal.”
• They do not have any idea what Fed balance sheet expansion does to the economy. The effect of interest rates on the economy are infinitely more clear to them — and even there, heterodox economists raise questions. At best, the believers in big balance sheets are ending up posting charts of the Fed’s balance sheet versus the S&P 500 — putting them in the esteemed intellectual company of internet Austrians. Their own mathematical theories would tell them that the effects would expected to be negligible.
• Changing balance sheet is difficult to do quickly. In fact, probably more slow-moving than fiscal policy. And of course, neoclassicals reject the use of fiscal policy as a stabilisation tool since it is slow-moving.

Anyways, since the Fed policy is now to slash rates to zero and then buy bucketloads of bonds every time there is a crisis/recession, readers might as well get used to this stupid debate.

1

There has been an ongoing debate on economics Twitter about price controls. I largely ignored this debate on a very bloody-minded basis: there is no prospect of any political party imposing price controls without something else radically changing in the economy. I know that many MMT proponents are fans of price controls, but I am not really in that camp. If we need a total mobilisation of societal resources for some task, sure. But beyond that, if you need to implement price controls to support some other policy, you really need to ask about the implementation of that other policy. In the context of the debate in the United States, it seems that enforcement of anti-trust in the spirit of decades ago might solve a good portion of the “price gouging” concerns that have come up.

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(c) Brian Romanchuk 2022