Friday, September 28, 2012

The Fed Should be a Day Trader

According to  Philadelphia Federal Reserve President Charles Plosser, the economy is "immune" to the Fed's stimulus efforts. Therefore we shouldn't even try to ease. I think Matt Yglesias does a very good job with responding to this argument, so in this post I want to draw attention to another fallacy Plosser makes that, as a result, makes the shift to a forward looking monetary regime even more important.

From a Thursday morning interview, the WSJ represents Plosser's views as:
“Monetary policy shouldn’t be a day trader,” Plosser said Thursday morning in an interview with Dow Jones Newswires and The Wall Street Journal. “I don’t think that’s a healthy focus for central banks…Policy making is too focused on short-term and not long-term views.
On face, it seems sensible. Of course the Federal Reserve shouldn't act in an erratic manner like a day trader, and of course it should focus on long-term views. But does one imply the other? I would say no -- to focus on long-term views, it makes sense to act like a day traders and look at real time market expectations of the long term.

Specifically, it should make sense for the Federal Reserve to worry about long-term inflation expectations, as they, by definition, represent the long-term views of the market. Given that the 5-year breakeven is barely above 2%, this means that, given what the market perceives of the economy and policy interventions, annual inflation is forecasted to be around 2% for 5 years. Given that inflation since the 2008 peak has been around 1.1%, a period of higher than average inflation should not be problematic. By the premise of efficient markets, the relatively low breakeven suggests that the Fed should take additional action. Perhaps there is some argument for why the breakeven is skewed, but traditional deviations from efficient markets, such as momentum trading, does not seems to form the basis of any of Plosser's arguments.

Plosser's comments also point out a more glaring hole: if the Federal Reserve isn't going to use indicies looking forward to guide monetary policy, what should it do instead? If we aren't allowed to forecast using the knowledge of the market, then the Fed is left to waiting for the data to come in and then to adjust economic policy many quarters after the original shock. This is actually worse for long-term views, as it opens the possibilities for downside for the financial market that isn't controlled for with policy.

To improve on the current situation, we could subsidize and construct an NGDP futures market in order to measure market expectations of future NGDP growth, and then the Federal Reserve can use those futures as a leading indicator on whether they should ease or tighten. These futures can even help in the unwinding process, as it lets the Fed know when the money supply has increased too quickly even before the actual numbers come in. Acting like a day trader is not inconsistent with an appreciation for long term fundamentals - the trick is to find a day-to-day measure and then use it to put the economy on stable, long run foundation.

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