Commitment, the State of the World, and Dissent

Here are some more thoughts with regard to my previous three posts (this one, this one, and this one.)



As academics, our policy arguments take place in the following way. We agree on what the state of the world is, but we may disagree on what model we should use to guide policy. Typically our arguments are in terms of the merits of the models at hand. Which model is better? Once we agree on that, then we can determine an operating rule for policy that tells the policymaker what action to take given any possible state of the world.



Policymaking on the FOMC seems not to work like that. Some of the non-economists on the committee are not aware of all the models available and how they work. The trained economists may have very different views concerning the merits of the models at hand. Over time, what seems to make the decision-making process work is to have the argument over the state of the world rather than over the theory. Pre-financial crisis, the question would be framed as follows. The FOMC members took as given that they did the right thing at the last FOMC meeting. The question for the current meeting was whether the state of the world was worse, better, or about the same relative to the last meeting. If things were worse, they would move the target for the fed funds rate down 1/4 point; if things were better, they would move up 1/4 point; if things were about the same they wouldn't do anything. Easy.



Post-financial crisis, things are not quite so easy, as now we supposedly have some more tools (I say supposedly because this is Bernanke's claim; I actually don't think so). Primarily, quantitative easing is on the table, and so is "extended period" language. But the policy decision is still framed in the same way. Is the state better or worse? Based on the answer to that question, the FOMC either tightens or eases. Then the question is how to do the tightening or easing.



Now, go to Bernanke's explanation for why the FOMC voted for the QE2 program in November 2010, i.e. this piece in the Washington Post. He discusses the dual mandate and some broader issues associated with the state of the world. Here is the important part:

The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed.

What Bernanke is telling you is that the FOMC has a decision rule, and for purposes of communicating with you, that decision rule takes account of inflation and unemployment. Unemployment is bad, and more inflation is good in this case. That's not the unemployment or inflation that he or someone else is forecasting, that's the unemployment and inflation we are actually observing. Then, he is telling you that the state of the world dictates that the FOMC should ease, following which he lays out the QE2 plan:

With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

So, it's possible that the FOMC might now think that QE2 did not work, in which case maybe they want to try something else. However, Bernanke seems to think it worked, at least that's what he said in this speech in February. As of the end of the QE2 program, Jim Bullard certainly thought the program worked, as did other Fed officials.



Thus, in terms of Bernanke's own publicly-stated criteria for what directs easing and tightening, Kocherlakota tells us the state is worse. In November 2010, the FOMC agreed that the state of the world directed them to ease. They eased, and according to them the easing worked. The state of the world is now better, so why ease further?



I think macroeconomists agree broadly on issues of commitment. The decision rules of policymakers need to be simple enough for the public to understand, and policymakers need to behave in ways that are consistent with their publicly-stated policy rules. If there is a change in a decision rule, that needs to be clearly-communicated.



In the case of last week's FOMC decision, there was certainly no statement that the FOMC was thinking about the world in a different way. Thus, presumably the decision rule has not changed. If that is true, than the FOMC's decisions should be consistent with what it has been doing. But Kocherlakota argues that is not the case, and I think he is right. A decision that may appear to make the Fed's behavior more predictable actually makes it less so. Instead of asking why the dissenters on the FOMC voted the way they did, we should be asking why the other people on the committee voted the way they did. And we should not have to ask that. We are now more confused, and that is not good.