If The Fed Is Always Wrong How Can Its Policies Ever Be Right?
One of the most curiously persistent surrealisms of Washington, DC is the reflexive deference given the Federal Reserve System. The Washington elite tends to accord more infallibility to the Fed than do Catholics the Pope.
Now comes one of the world’s top monetary reporters, Ylan Q. Mui, to make a delicate observation at the Washington Post’s Wonkblog, in Why nobody believes the Federal Reserve’s forecasts. Mui:
“The market recognizes that the Fed has repeatedly erred on the optimistic side,” said Eric Lascelles, chief economist at RBC Global Asset Management. “Fool me 50 times, but not 51 times.”
Even the government’s official budget forecasters are dubious of the Fed’s own forecast.
This is a theme that Mui has touched on before. In 2013, she wrote Is the Fed’s crystal ball rose-colored?:
The big question is whether Fed officials can get it right after years in which they have regularly predicted a stronger economy than the one that materialized. In January 2011, Fed officials predicted that GDP would grow around 3.7 percent that year. It clocked in at 2 percent. In January 2012, they anticipated growth of about 2.5 percent. We ended up with 1.6 percent.
To give Ms. Mui’s competition its due, Dr. Richard Rahn at the Washington Times last April crisply noted:
The Federal Reserve had forecast the U.S. economy to grow about 4 percent near the beginning of each year for the last five years. But during each year, the Fed was forced to reduce its forecast until it got to the actual number of approximately 2 percent. (Other government agencies have been making equally bad forecasts.) These mammoth errors clearly show that the forecast models the official agencies use are mis-specified and contain incorrect assumptions.
What’s going on here?
A good bet would be that there’s a problem with the Fed’s reliance on an arcane art. This art is designated “Dynamic Stochastic General Equilibrium” modeling.
Sound scientific? Well…
With admirable intellectual honesty an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group, Marco Del Negro, Wharton Ph.D. student Raiden Hasegawa and University of Pennsylvania professor of economics Frank Schorfheide (speaking for themselves and not the Fed) open a two part analysis at the NY Fed’s own excellent Liberty Street Economics, Choosing the Right Policy in Real Time (What That’s Not Easy):
Model uncertainty is pervasive. Economists, bloggers, policymakers all have different views of how the world works and what economic policies would make it better. These views are, like it or not, models. Some people spell them out in their entirety, equations and all. Others refuse to use the word altogether, possibly out of fear of being falsified. No model is “right,” of course, but some models are worse than others, and we can have an idea of which is which by comparing their predictions with what actually happened.
The authors go on to conclude in the second part of their analysis:
In the end, we have shown that policy analysis in the very oversimplified world of DSGE models is a pretty difficult business. Contrary to what it may sometimes appear from listening to talking heads, deciding which policy is best is very rarely a slam dunk.
Dynamic Stochastic General Equilibrium modeling sure sounds amazing. That said let’s be blunt. If NASA suffered from comparable inaccuracy the manned spaceflight program would have been shut down by an endless series of Challenger-type catastrophes many years ago. With monetary forecasts this bad is it any wonder the American economy continually crashes and burns?
As I have noted before, yet it bears repeating, Prof. Reuven Brenner powerfully has called our current system to account:
[M]acro-economics is now [astrology’s] modern incarnation: Only instead of stars, macro-economists look at “aggregates” gathered religiously by governments’ statistical agencies – never mind if the country has a dictatorial regime, be it left, right or anything in between, or has large black markets, as Italy and Greece do, where tax evasion has long been the main national sport. So let us first forget about this “macro” stuff, whose beginnings are almost a century old, and offer a simple alternative for shedding light on the situation today and on possible solutions, hopefully demolish this modern pseudo-”science” once and for all.
Classical liberal economist Axel Kaiser anticipated this line of argument in his book Intervention and Misery: 1929 – 2008 by calling for the “end of the mystery [which] implies the end of the witch doctors and the definite defeat of the economic astrology that has prevailed in recent decades.”
This line of criticism, while apparently alien to the Fed, is nothing new. Hayek, in his Nobel Prize acceptance speech The Pretence of Knowledge tartly observed:
We have indeed at the moment little cause for pride: as a profession we have made a mess of things.
It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences — an attempt which in our field may lead to outright error. It is an approach which has come to be described as the “scientistic” attitude — an attitude which, as I defined it some thirty years ago, “is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed.” I want today to begin by explaining how some of the gravest errors of recent economic policy are a direct consequence of this scientistic error.
That said, nobody, not even the great Hayek, nailed the problem better than did Hans Christian Anderson in The Emperor’s New Clothes:
One day, two rogues, calling themselves weavers, made their appearance. They gave out that they knew how to weave stuffs of the most beautiful colors and elaborate patterns, the clothes manufactured from which should have the wonderful property of remaining invisible to everyone who was unfit for the office he held, or who was extraordinarily simple in character.
“These must, indeed, be splendid clothes!” thought the Emperor. “Had I such a suit, I might at once find out what men in my realms are unfit for their office, and also be able to distinguish the wise from the foolish! This stuff must be woven for me immediately.”
And now the Emperor himself wished to see the costly manufacture, while it was still in the loom. …
“Is not the work absolutely magnificent?” said the two officers of the crown, already mentioned. “If your Majesty will only be pleased to look at it! What a splendid design! What glorious colors!” and at the same time they pointed to the empty frames; for they imagined that everyone else could see this exquisite piece of workmanship.
“How is this?” said the Emperor to himself. “I can see nothing! This is indeed a terrible affair! Am I a simpleton, or am I unfit to be an Emperor?
So now the Emperor walked under his high canopy in the midst of the procession, through the streets of his capital; and all the people standing by, and those at the windows, cried out, “Oh! How beautiful are our Emperor’s new clothes! …
“But the Emperor has nothing at all on!” said a little child.
If the Fed is making policy based on consistently wrong predictions how good can its policy consistently be? If its forecasts consistently are wrong — as now is undeniable — on what is it basing policy? Guesswork (more pretentiously phrased as “discretion”)?
America deserves some candor. A frank admission of “guesswork” — even educated guesswork — would better our understanding of why American workers have been for the past 15 years, and are today, engaged in painful belt-tightening. And, forgive the heresy, just maybe there is a better way than guesswork.
Ylan Mui is, as she ought to be, far too politic to be so blunt. Thus it falls to me, in my role as the simpleton on this beat, to declare: The Emperor has no clothes.
I’d welcome being set straight if the Board of Governors is prepared to contest this simpleton. Surely Chair Yellen or Vice Chair Fischer — both first rate economists and authentically honorable public servants — will support the Brady-Cornyn Centennial Monetary Commission legislation lately approved by Chairman Hensarling’s House Financial Services Committee.
So let the Fed set me straight by entering the beautiful canopy of this Commission to make the case for the exceptional beauty of its handiwork. If, rather, the Fed raises objections to a Commission (to which it will appoint an ex officio commissioner)… perhaps my declaration is not, after all, that of a simpleton. In the event of Fed opposition Congress should be even more eager to enact this Monetary Commission.
I say the Emperor has no clothes. If clad, high time to parade their exceptional beauty.
Pass the Centennial Monetary Commission. Let’s see the Emperor’s clothes.
Originally posted on Forbes.com.