Tuesday, February 26, 2013

The Federal Reserve and the Tiger by the Tail

Bookmark this post, it will come in handy to show once again that Federal Reserve models on how the economy works have no basis in reality.

Economists at the New York Federal Reserve are out with a fascinating series of projections on the future of the economy, including the Fed Funds rate.  They first forecast the economy using an estimated dynamic stochastic general equilibrium (DSGE) model.

This is the result from the model:

Here's the Fed providing more data on the model in chart form. The model shows short-term interest rates skyrocketing, but assumes that the climb does not start until the second quarter of 2015.

Notice how in this model the Fed Funds rate climbs from 0.25% to eventually 4.5%. The Fed economists don't like this result (which also shows strong gains for economic activity in 2014, but I want to focus on the Fed Funds projection). They write about the model overall:
Why do we get such (implausibly) large effects? The model allows us to decompose the interest-rate announcement effects on the macroeconomy into two parts: 1) the effects of credible announcements about future short‑term policy rates on long‑term bond yields, and 2) the effects of the resulting change in long‑term bond yields on economic activity and inflation. Is the excess response due to an over-reaction of long‑term bond yields to interest-rate announcements, or to an excess response of output and inflation to given changes in long‑term bond yields?

The problem lies mostly in an over-reaction of long rates. The chart [above] shows that an extension of the forward guidance by two quarters would lead to large declines in expected short‑term rates far into the future. The blue solid line in the chart refers to the counterfactual experiment in which the FOMC commits to keeping the FFR low until second-quarter 2015.  It shows that, as a result of this commitment, the short‑term interest rate is expected to deviate substantially from the baseline scenario for many years. 
As I said, the Fed economists don't like the overall result, so they monkeyed with the model:
This finding [the one above] suggests that the experiment conducted does not properly capture the effects of forward guidance considered by the FOMC. A possible way to obtain more plausible responses is to recognize that forward guidance provides more information about short‑term interest rates in the subsequent few years than about rates very far into the future. We thus consider an alternative experiment in which forward guidance is provided but the path of the FFR far in the future is constrained not to deviate too much from its initial path.
And their new model looks like this:

They then review their new creation:
 When we do things this way, the outcome is much more reasonable. The chart [above] shows the model's predictions for real GDP growth, core PCE inflation, and the FFR conditional on alternative assumptions about the future path of the interest rate. The black solid lines show the historical data and the dashed red lines show the model's baseline forecast. 
In the second chart, the Fed Funds rate appears to increase in the year 2016 to the 1.50% to 1.75% range versus the first chart, where the rate appears to hit 2.0% in 2016. Though the economists fail to provide the detailed data to know exactly what the models show for these time periods and go further to obfuscate matters by showing charts for different time periods for the two models.They call the second model constrained. Indeed! The first model is drawn out in the chart until the year 2027, the second chart is eleven years shorter.

There is further hedging and backflips throughout their post, but what I believe is most instructive is their operating under the assumption that the Fed Funds rate, in both models, will remain at 25 basis points until the second quarter of 2015. While they are not "forecasting" this but merely making it as an assumption, I believe it reveals how off base Fed economists are. The chances that the Fed funds rate will be at 25 basis points into the second quarter of 2015, appears extraordinarily slim. It is impossible to make exact projections about the economy, and interest rates, because of the nature of the world (It is impossible to know all the factors pushing on an economy), but important macro factors are influencing interest rates higher. The Fed money printing, itself, is flooding the economy with money. If the Fed stops, this will surely result in higher rates, BUT if the Fed continues pumping money at current rates, price inflation is likely to heat up and push rates higher. Thus, the Fed is working its way into a potential tiger by the tail situation, where, whichever way it decides to operate (more printing or less), the result will be higher interest rates, much sooner then the Fed expects.

In other words, the Fed model appears to have everything, except the tiger and the tail.

1 comment:

  1. Wow! How scientifical!!
    Just target the result you want and work backwards.
    Not like that unscientific Austrian stuff.

    Lies, damn lies, and statistics.