In the News
This was a big part of the news on and around September 21:
“The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. In support of these goals, the Committee decided to raise the target range for the federal funds rate to 3 to 3-1/4 percent and anticipates that ongoing increases in the target range will be appropriate.”
Here “the Committee” is the Federal Open Market Committee (FOMC) that is entrusted with the conduct of monetary policy in the US. This committee is comprised of members of the Federal Reserve Board and some (not all) of the presidents of the Federal Reserve Banks scattered around the country. Let’s just agree to call this whole apparatus the Fed.
The Fed sets monetary policy. It does so partly through the FOMC which meets every 6 weeks. The statement above came from its policy announcement following the FOMC meeting on September 21.
My goal in this essay is not to evaluate this policy per se. Bur rather use it as an opportunity to talk more generally about concerns over the conduct of monetary policy.
Behind the FOMC Statement
What exactly is the economics here? What links the actions of the Fed to inflation and real economic activity over time?
These are surprisingly hard questions. I think the honest truth is simple: those designing monetary policy really do not know.
So let me explain why I hold such a view by telling a story. I used to be a frequent visitor at US regional Federal Reserve Bank. At one in particular, I would often have a direct conversation with the bank president about the state of the economy and the current monetary policy stance. The first part was always of interest. The second part of the conversation always went nowhere.
I would explain that I had no idea about monetary policy since I could not get over two intellectual roadblocks. First, why do people hold money? Second, why do changes in the money supply have real effects?
Admittedly these are academic puzzles. Clearly, we all hold money. And, when the Fed takes actions, there is a response to its policy.
Still, our basic economic models do not generally have a role of money. And those that do have a strong prediction: monetary policy has an impact on prices but not real quantities, such as the level of economic activity. From this perspective, there is simply no basis in economic theory for the so-called “channels of monetary policy” that are taken as gospel within monetary policy institutions.
This is not to say that there are not any economic models lying behind the FOMC actions. There are numerous outstanding economists working inside of the Federal Reserve system. Ben Bernanke just shared a Nobel Prize in Economics. These economists have developed and continue to use models that help predict the impact of monetary policy. But, to be honest, these models do not really respond to the concerns raised here. They force output and employment to respond to monetary policy. And in some leading models there is not even any money held by private agents.
Who Needs a Model Anyways?
Models are the bread and butter of economics. Without a good model, we are just lost. That is what I was trying to say to the bank president, we don’t have a model for the conduct of monetary policy.
I am not sure that the bank president understood what was under the hood of the monetary policy analysis. He did though seem comfortable driving that vehicle. In the end, he had little interest in the part of our conversations about monetary policy.
What makes a model a good one? It is not realism: by design economic models are abstractions, allowing us to focus on details. That makes economists some complex combination of applied mathematicians and artists.
There are two essential ingredients to an economic model. First, there is optimizing behavior by economic agents such as households, firms and even the government. So, for example, households make choices about labor supply and consumption and savings etc. with the objective to make themselves happy subject to a budget constraints. Firms maximize profits, acting on behalf of shareholders. And the government, in the best of all worlds, makes decisions on behalf of the households in the economy.
The choices must be consistent in two important ways. First, markets must clear: yes this is the good old, supply == demand! Second, to the extent that decisions, like savings, involve expectations of the future, those expectations must be consistent with the economic model: this is called rational expectations. This does not mean that we can all see the future perfectly. Rather, while we make errors without predictions, those errors should not be something we could foresee.
A successful economic model has these components. And, on top of that, is able to replicate key features of the data. Once that is achieved, then a model can be useful for policy interventions.
I am not convinced that the models used by the Fed in making monetary policy satisfy these criteria. In particular, the requirement of optimizing behaviour is not generally met.
Stock Market Response
The FOMC announcement was coupled with this outcome as reported by CNBC:
Stocks fell in volatile trading Wednesday after the Federal Reserve raised rates by 75 basis points and forecast more sizeable rate hikes ahead in its fight to tame surging inflation.
The Dow Jones Industrial Average slid 522.45 points, or 1.7%, to close at 30,183.78. The S&P 500 shed 1.71% to 3,789.93, and the Nasdaq Composite slumped 1.79% to 11,220.19.
From that same CNBC report, we are told that there is no news in the Fed announcement
The Fed raised rates by the widely expected 75 basis points and said it expects its so-called terminal rate to reach 4.6% to fight persistently high U.S. inflation.
Putting these two quotes together is interesting and a bit perplexing. In response to the first of these reports, I would say that there must have been some element of a surprise, either in the action of the Fed or in the announcement. This news, i.e. the unexpected element of the Fed action, would cause the stock market to respond. Else, if the action was totally anticipated, then it would have already been integrated into the valuation of stocks, with no response by the stock market to the announcement.
One possible way to understand this is that while the action was anticipated, the working within the announcement contained some surprise about the current state of the economy. This might be in terms of an assessment of the current economic situation or, more likely, something that changed beliefs about future actions by the monetary authority. Looking back at the statement, the clause “ … and anticipates that ongoing increases in the target range will be appropriate.” could be the news.
By the way, we just used a model of the stock market. In that model, the value of a stock was based upon the discounted present value of expected dividends. To the extent the expected dividends were impacted by monetary policy, that would be immediately reflected in stock prices. So an action from the Fed would affect stock prices when there was news about that action, not when it actually occurred.
What else could we do?
The easy answer is to develop better models. Of course this remains a continuous academic pursuit. And for sure some progress has been made, particularly in the development of models that explain money demand.
While this research progresses, the Fed remains in operation. To me, the Fed ought to focus on two main activities:
targeting inflation and using its tools to achieve that target;
be on call when needed to deal with crisis.
For each of these activities, we do have something this is much closer to a consensus among economists. Over longer periods of time, the rate of money growth determines the rate of inflation. By consensus I mean that most monetary models have this property and it seems to hold well in the data.
The disagreement is about the shorter terms effects of monetary policy on inflation and output (unemployment). Perhaps it would be best to just give up on attempts to fine tune the economy, as in the September 21 FOMC statement.
The second activity, which involves Ben Bernanke both in terms of his research on the Great Depression and his tenure as Fed Chairman, concerns the role of the monetary authority during a crisis. Models of crises generally ascribe to the Fed a role in stabilizing an otherwise fragile financial system. This seems to be a critical role of the monetary authority.
The structure of the Federal Reserve System is a subject worthy of independent study, both from a historical perspective and in understanding modern events. That structure is explained in full detail here.
Those who favor these models think of this as a real strength.
This is related to the efficient markets hypothesis for stock markets.