How good has the Federal Reserve been at predicting how its policies will affect the behavior of the U.S. economy? Not that good.
Years of rock-bottom interest rates and trillions of dollars in monetary stimulus have done little to spur inflation, as the Fed has predicted it would. So, what's wrong with the Fed models?
John Dizard of the Financial Timeshas taken on the economic forecasting approach used by the Federal Reserve.
"My problem is not just that the DSGE [dynamic stochastic general equilibrium modeling] group has failed to achieve its publicly stated goals," Dizard said. "It has pursued policies that lead to results that not only defy common sense but result in perverse outcomes." He rails against the economics profession: "Even within the Profession, the DSGE's obliviousness to the mechanics of financial markets, let alone crises, has been remarked upon."
The Dynamic Stochastic General Equilibrium model is the macroeconomic model of the neo-Keynesian school of economics.
Dizard argues "you have to know the DSGE to get a professional job in a central bank." But then "nobody outside the current or former denizens of central banks, ministries of finance or university economics departments even knows what the model is. Because it does not work, it and its cousin models have little if any forecasting power. They are poor or even deceptive descriptions of how market economies function.... The DSGE members explain away the lack of interest in their model in the wider world by its utility as a 'policy tool.'"
Embedded within the DSGE model is the so-called "Phillips Curve," the empirical relationship between inflation and unemployment that indicates that, in the short-term, there exists a trade off that can be exploited by policy makers to meet the U.S. Congressional mandate for the Fed to achieve low levels of unemployment for the country.
Although the Phillips Curve was introduced to the economics profession in the late 1950s, it continues to be an important part of today's analysis. Just note the reference of Fed Vice-Chairman Stanley Fischer to the "flat slope of the Phillips Curve" in a recent speech.
In the speech, Fischer tried to explain why inflation is so weak and why the Fed's forecasting of inflation in recent years has been so bad.
There are two ways to consider Dizard's assessment of the Fed's dependence on the DSGE model. The first has to do with the Phillip's curve.
The Phillip's curve was recognized to be an empirical phenomenon, applicable, at best, only in the short-run. Nobel prize-winning economist Milton Friedman called attention to this in his Presidential speech to the American Economic Association in 1966.
The Phillips curve depends upon the fact that an economy's inflationary expectations are based, at least initially, on what actual inflation has been. Thus, policy makers, if they can cause inflation to be slightly higher than current expected inflation, will enable more workers to be put to work and the unemployment rate will drop.
However, people can only be fooled for so long, Friedman argued, and they will adjust their expectations for inflation upward to reflect the new inflation the policy makers were able to achieve.
Then, the policymakers would have to create even more inflation to "fool" people so that unemployment can remain at the lower level.
According to Friedman, this process will have to continue for the economy to remain at the lower "target" rate of unemployment the policy makers want to achieve.
One problem with this is that people are assumed to continue to build expectations upon past rates of inflation actually achieved. What will happen if people come to expect that policy makers will continue to bump up the level of inflation? Won't people come to expect the behavior of the policy makers and adjust their inflationary expectations based upon what they have seen policy makers do and not upon what actual inflation turned out to be?
This would mean that the Phillip's curve tradeoff between inflation and unemployment would bounce around over time and break down any close relationship that might have once held between these two variables.
Maybe this is why economists have found the empirical relationship to be so bad over time and so hard to derive any coherent policy prescriptions from the estimated models.
The second remark to Dizard's piece has to do with the changes in the financial sector of the U.S. economy since the 1960s. Dizard refers to this as "DSGE's obliviousness to the mechanics of financial markets."
DSGE models have only abbreviated financial sectors. How these models can be expected to reflect the real world of today with only minor treatments of the financial sector is mind-boggling.
One only needs to refer to the recent work of another Financial Times writer, John Kay and his book Other People's Money, to understand how "out of touch" these models are with reality. Kay examines how the financial sector has grown since the 1960s and hired an increasing number of people. Kay also looks at how the relative output of the sector to total output has grown, and how financial institutions have hired individuals with more and more education. This latter development has occurred as the sector has moved away from just intermediary services to depend primarily on the trading activities created by monetary stimulus.
These trading activities have grown because, as Dizard quotes the economist Bernard Connolly as saying that under the guidance of the DSGE, "policy driven by the canonical model needs bigger bubbles and a trend towards even lower real rates to defer a deep recession."
This is just what Friedman predicted in the 1960s.
Over the past fifty-some years, monetary policy has had less impact on real economic growth to the point that the current economic recovery, in its twenty-sixth quarter, has only grown at an annual, compound rate of about 2.2%.
Dizard quotes Connolly, "Some macroeconomists now think the equilibrium real rate is negative. But how can a capitalist society work with permanently negative real rates?"
Therefore, it is not surprising that there is so much uncertainty in the financial markets. If the Fed's economic models "have little if any forecasting power," then Fed officials cannot have much confidence in what their policies might achieve.
The statements that the Fed makes, therefore, do not provide forward guidance but rather forward confusion.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.