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Bernanke Frets Over Sherlock Holmesâs Next Stop: Caroline Baum
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Commentary by Caroline Baum
Oct. 19 (Bloomberg) -- Federal Reserve policy makers like to explain the world in terms of feedback loops, except those of their own making.
Last year, a negative feedback loop threatened to deepen the financial crisis as a weak economy and a teetering banking system led to layoffs and production cutbacks, which led to even bigger declines in output and employment.
Last month, officials heralded the onset of a âpositive feedback loop,â wherein better financial conditions and stronger growth in employment and output lead to a stronger stock market and improved financial conditions, according to minutes from the Fedâs Sept. 22-23 meeting.
At some point, of course, the loop gets broken. Otherwise, the economy would head in one direction, up or down, forever.
Where is the discussion of the Fedâs inflation expectations feedback loop, which yields no feedback and less information?
The Fedâs treatment of inflation expectations in the minutes released last week still has my head spinning. See if you can follow the thread.
-- Inflation expectations are a key determinant of inflation. (This is an oath central bankers must swear to before theyâre taught the secret handshake and admitted into the club.)
-- The size of the Fedâs balance sheet affects inflation expectations.
-- Therefore, to keep inflation expectations âwell anchored,â the Fed must communicate that it has both the tools and the willingness (means and motive) to begin withdrawing monetary accommodation at an appropriate time and pace to prevent an increase in inflation.
âHolmes-Moriarty Problemâ
This sets up an interesting âHolmes-Moriarty Problem,â or the pitfalls of interdependent decision-making.
In Sir Arthur Conan Doyleâs story, âThe Final Problem,â Sherlock Holmes leaves London by train with his arch-enemy, Professor James Moriarty, in hot pursuit. Holmes has to decide at which station to get off. Moriarty is trying to figure out where Holmes will get off.
For our purposes, the outcome is less important than the process. Itâs a classic case of I think that you think that I think that you think, which ends up helping neither party.
Whatâs the application to the Fed?
The public is looking at the Fed to formulate its expectations about inflation. The Fed is the sole proprietor of the nationâs printing press, so inflation expectations start and end with the Fed.
The Fed is looking at the publicâs expectations for guidance as to what to do to re-shape those expectations, if necessary, and inflation itself.
Expectations Loop-de-Loop
If I have this right, weâre waiting for the Fed to do or say something to help us decide whether we should hoard cash (because we expect the dollar to buy more tomorrow if prices are falling) or buy and hoard hard goods (if we expect inflation to diminish the dollarâs purchasing power).
The Fed, in turn, is waiting for us to do something so it can decide what to do: either raise the volume on its anti- inflation rhetoric with talk of exit strategies and price stability; or talk softly to allay fears of premature rate increases to keep market rates from rising.
This is hard enough for your average MBA graduate on Wall Street to understand. And the Fed expects the average Joe on the auto-assembly or unemployment line to have a well-formulated view of inflation expectations?
Itâs not that people arenât rational; they are. Itâs that they lack perfect information.
Just Ask Randa
Two years ago, fed up with the hijacking of the economics profession by rational expectations theory, I did an informal street survey on inflation expectations. The most popular answer to a question on the current rate of inflation was âno clue.â That was followed by âno ideaâ in response to a question on expectations for inflation over the next 12 months.
Of the 40 people I surveyed, the most astute prognosticator turned out to be Randa, the psychic, whose services a survey participant was touting. In March 2007, Randa told me she was looking for a âvery dramatic fallâ in the stock market in late September, early October. I knew I should have listened to Randa.
If I read the minutes and other Fed communications correctly, policy makers are relying on us to tell them what to do, weâre relying on them for direction, and weâre locked in this no-way-out feedback loop that provides no useful information for either party.
Real Money
Letâs say, for argumentâs sake, the Fed communicated its intent to create inflation to ease the federal governmentâs huge debt burden. The public would go out and buy goods in response, reducing its cash balances.
What happens if the Fed doesnât follow through on its promise? If the broad money supply doesnât increase -- reserves are the raw material, not the finished product -- the publicâs buying behavior will result in a one-time increase in the price level. When we discover prices arenât rising, we dump our goods, which sends the price level back down.
For the record, M2 has shown no growth in the last six months.
Now, itâs entirely possible Iâm missing something here. And Iâll grant that inflation expectations can contribute to, or quicken, inflation.
To say that you and I have the ability to create inflation on our own flies in the face of monetary theory. If we did have a set of keys to the printing press, the Fed would have more than just inflation expectations to funnel through its feedback loop.
Last Updated: October 18, 2009 21:00 EDT
Bernanke Frets Over Sherlock Holmesâs Next Stop: Caroline Baum
Share | Email | Print | A A A
Commentary by Caroline Baum
Oct. 19 (Bloomberg) -- Federal Reserve policy makers like to explain the world in terms of feedback loops, except those of their own making.
Last year, a negative feedback loop threatened to deepen the financial crisis as a weak economy and a teetering banking system led to layoffs and production cutbacks, which led to even bigger declines in output and employment.
Last month, officials heralded the onset of a âpositive feedback loop,â wherein better financial conditions and stronger growth in employment and output lead to a stronger stock market and improved financial conditions, according to minutes from the Fedâs Sept. 22-23 meeting.
At some point, of course, the loop gets broken. Otherwise, the economy would head in one direction, up or down, forever.
Where is the discussion of the Fedâs inflation expectations feedback loop, which yields no feedback and less information?
The Fedâs treatment of inflation expectations in the minutes released last week still has my head spinning. See if you can follow the thread.
-- Inflation expectations are a key determinant of inflation. (This is an oath central bankers must swear to before theyâre taught the secret handshake and admitted into the club.)
-- The size of the Fedâs balance sheet affects inflation expectations.
-- Therefore, to keep inflation expectations âwell anchored,â the Fed must communicate that it has both the tools and the willingness (means and motive) to begin withdrawing monetary accommodation at an appropriate time and pace to prevent an increase in inflation.
âHolmes-Moriarty Problemâ
This sets up an interesting âHolmes-Moriarty Problem,â or the pitfalls of interdependent decision-making.
In Sir Arthur Conan Doyleâs story, âThe Final Problem,â Sherlock Holmes leaves London by train with his arch-enemy, Professor James Moriarty, in hot pursuit. Holmes has to decide at which station to get off. Moriarty is trying to figure out where Holmes will get off.
For our purposes, the outcome is less important than the process. Itâs a classic case of I think that you think that I think that you think, which ends up helping neither party.
Whatâs the application to the Fed?
The public is looking at the Fed to formulate its expectations about inflation. The Fed is the sole proprietor of the nationâs printing press, so inflation expectations start and end with the Fed.
The Fed is looking at the publicâs expectations for guidance as to what to do to re-shape those expectations, if necessary, and inflation itself.
Expectations Loop-de-Loop
If I have this right, weâre waiting for the Fed to do or say something to help us decide whether we should hoard cash (because we expect the dollar to buy more tomorrow if prices are falling) or buy and hoard hard goods (if we expect inflation to diminish the dollarâs purchasing power).
The Fed, in turn, is waiting for us to do something so it can decide what to do: either raise the volume on its anti- inflation rhetoric with talk of exit strategies and price stability; or talk softly to allay fears of premature rate increases to keep market rates from rising.
This is hard enough for your average MBA graduate on Wall Street to understand. And the Fed expects the average Joe on the auto-assembly or unemployment line to have a well-formulated view of inflation expectations?
Itâs not that people arenât rational; they are. Itâs that they lack perfect information.
Just Ask Randa
Two years ago, fed up with the hijacking of the economics profession by rational expectations theory, I did an informal street survey on inflation expectations. The most popular answer to a question on the current rate of inflation was âno clue.â That was followed by âno ideaâ in response to a question on expectations for inflation over the next 12 months.
Of the 40 people I surveyed, the most astute prognosticator turned out to be Randa, the psychic, whose services a survey participant was touting. In March 2007, Randa told me she was looking for a âvery dramatic fallâ in the stock market in late September, early October. I knew I should have listened to Randa.
If I read the minutes and other Fed communications correctly, policy makers are relying on us to tell them what to do, weâre relying on them for direction, and weâre locked in this no-way-out feedback loop that provides no useful information for either party.
Real Money
Letâs say, for argumentâs sake, the Fed communicated its intent to create inflation to ease the federal governmentâs huge debt burden. The public would go out and buy goods in response, reducing its cash balances.
What happens if the Fed doesnât follow through on its promise? If the broad money supply doesnât increase -- reserves are the raw material, not the finished product -- the publicâs buying behavior will result in a one-time increase in the price level. When we discover prices arenât rising, we dump our goods, which sends the price level back down.
For the record, M2 has shown no growth in the last six months.
Now, itâs entirely possible Iâm missing something here. And Iâll grant that inflation expectations can contribute to, or quicken, inflation.
To say that you and I have the ability to create inflation on our own flies in the face of monetary theory. If we did have a set of keys to the printing press, the Fed would have more than just inflation expectations to funnel through its feedback loop.
Last Updated: October 18, 2009 21:00 EDT