During 2020, public health authorities occasionally put out false or misleading information, or delayed useful innovations, based on armchair theories about how the public reacts to risk and uncertainty. I recall pundits like Alex Tabarrok and Tyler Cowen pointing out that public health authorities are generally not experts on social psychology, and thus should not try to micromanage the public’s mood.
A similar problem can occur with monetary policy. A new paper by Michael Bauer and Eric Swanson cites a recent example:
For example, in the minutes of the FOMC meeting on March 15, 2020, participants were concerned that a strong monetary easing surprise “ran the risk of sending an overly negative signal about the economic outlook.” [p. 55, footnote]
I’ve spent much of my life studying market reactions to monetary policy news, and have the strong impression that the markets are much more worried about what the Fed doesn’t know than what it does know. Both the Fed and the markets have pretty similar information regarding macroeconomic aggregates and asset market price movements. The biggest problems arise when the Fed has the wrong model, and makes a decision that market participants view as likely to lead to a negative outcome for the economy. Lots of these bad decisions occurred in the early 1930s, and again in late 2008. The fear isn’t that a rate cut will expose an already weak economy, it’s that the Fed won’t cut rates when it’s clear to market participants that a rate cut is appropriate.
The preceding is based on my reading of monetary history, not a rigorous study of the data. But Bauer and Swanson have done such a study and also conclude that the Fed should simply do the right thing, and not second guess how markets will react to their moves:
Our results also have important implications for central bank communication and the conduct of monetary policy. First, along with Bauer and Swanson (2021), we find little or no evidence that FOMC announcements have a substantial “Fed information effect” component. Although the minutes of recent FOMC meetings reveal that some participants worried about the potential for counterproductive information effects, our results indicate that policymakers have little need to fear that information effects might attenuate the effects of their announcements, except possibly in exceptional circumstances (which our results cannot rule out). [p. 55]
The Fed should focus on doing the right thing, and not try to second guess how the market will interpret sound monetary policy.
READER COMMENTS
Spencer
Apr 19 2023 at 9:22am
The FOMC is not “independent”. The American Bankers Association runs the game. The ABA, with its well-funded lobbyists, “routinely spends more money influencing legislation, than all other industry and labor groupings.”
Spencer
Apr 19 2023 at 9:34am
Lawrence K. Roos, past President, FRB-STL was cited, in the WSJ’s “Notable and Quotable” column, April 10, 1986, as follows:”…I do not believe that the control of money growth ever became the primary priority of the Fed. (i.e., under Volcker). I think that there was always and still is a preoccupation with stabilization of interest rates.”
Economists think banks are intermediaries. Just google it. Ask chat gpt.
Under Powell, the Keynesian economists have achieved their objective, that there is no difference between money and liquid assets.
Economists can’t differentiate between a single bank and the system.
The increased lending capacity of the financial intermediaries is comparable to the increased credit creating capacity of the commercial banks in only one instance; namely, the situation involving a single bank which has received a primary deposit and all newly created deposits flow to other banks in the system.
Jon Murphy
Apr 19 2023 at 10:19am
Great post. You wrote something similar to this back at the beginning of the pandemic about how Fauci was playing at being an amatuer social psychologist and economist in his policies (that idea is something picked up, ran with, and it turned into a chapter of my dissertation and publication).
I think your point is crucial in understanding public policy. A single expert (or even a group) cannot direct policy because they must necessarily venture outside of their expertise. The world is not broken up into little academic diciplines, and never shall they meet. Everything is intimately interconnected.
Scott Sumner
Apr 19 2023 at 11:59am
Thanks for doing that paper. It’s an important topic.
Jose Pablo
Apr 19 2023 at 12:53pm
Both the Fed and the markets have pretty similar information regarding macroeconomic aggregates and asset market price movements. The biggest problems arise when the Fed has the wrong model, and makes a decision that market participants view as likely to lead to a negative outcome for the economy.
This has always puzzled me. If the FED main job is to stabilize the growth of the economy in the long run and if this is good for the economy then, steering the economy in the right direction should ALWAYS have a positive impact in market valuations (the “absence of steering” should lead to a worst outcome … that’s the reason for the “steering”!)
In this case valuations should negatively react to fed decisions only (or mostly) if they think that the Fed is doing the wrong “steering” …
… and yet valuations react like this too often for this “logic” to be true (I think)
There are alternatives though:
One is that markets can also be wrong when the Fed is right. So, it is enough with one of them (the fed or the markets) to be wrong for valuations to drop when the fed does (or doesn’t) anything. That should increase the odds of this negative reaction
Other is that the markets WERE wrong (before the fed action) and the Fed “iluminate”them and they reassess their valuations with the “new” information “provided” by the Fed
Maybe this last case is the one responsible for the prevalence of negative reactions of valuations to fed actions … which causes me a kind of cognitive dissonance since I tend to believe that markets (distribute intelligence with skin in the game) should be right more frequently than the Fed (“experts in models” with ego problems to recognize their mistakes)
Or maybe the Fed is not a “market reader” but a “market maker” and so it is right even when it is wrong (what the Fed believes to be the “real situation” is more relevant to market valuations that what the reality really is)
Bill Conerly
Apr 19 2023 at 5:12pm
Yes, and . . .
The Fed’s model of inflation has a large input from expected inflation (plus the gap between actual output and potential output). In 2021, the Fed believed that their continual statements saying they were committed to keeping inflation in check would lead to “well anchored” expectations, preventing inflation from accelerating. And then it did. It’s hubris for anyone to think he can manage public beliefs.
Thomas Hutcheson
Apr 20 2023 at 3:55pm
Even more to the point, the Fed should not make unconditional predictions about its own future actions. It can say things like, “If inflation continues at below/above target rates we may have to take more vigor action to achieve out target.” That just reassures the market that policy has not changed.
Thomas Hutcheson
Apr 20 2023 at 4:05pm
But if the Fed believes that, say, an interest rate increase/decrease will be interpreted as information about the economy, it might need to increase/decrease the rate by even more or make some other simulative/contractionary adjustment in another instrument to offset the expected reaction. It might even in the press conference point to the “exaggerated” bullishness/bearishness to explain its actions.
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