Saturday, July 27, 2013

China's Circularity Problem

In the context of future looking monetary policy, the circularity problem refers to the problem that central banks face when they try to use market signals to guide policy. The general problem is that the market signals may include expectations of future policy in addition to their expectations of future shocks, so that the market signals fool the central bank into pursuing inappropriate policy. For example, if the private sector believes there will be a large shock to consumer demand in the future, but also believes that the central bank will fully offset the shock, then market expectations of inflation may not change. If the central bank looks at the inflation expectations and concludes that there is no threat to aggregate demand, the central bank may end up not offsetting the shock, and the markets fall in response.

The most recent example of this in U.S. financial markets is the Fed taper. Before the Fed taper talks, the general expectation was that quantitative easing would continue into the indefinite future and that there would be no premature tightening. As a result, the stock market seemed very resilient because there were expectations of strong growth conditional on Fed easing. The Fed misinterpreted these expectations as independent of the Fed's policy of QE and decided to tighten.

However, fiscal authorities can also face the same circularity problem. If an economy is highly dependent on government spending, then real economic conditions may be determined conditional on expected future fiscal easing. And if the fiscal authority sees the strong current economic conditions as a justification for austerity, then this too may cause a fall in growth in the same way that a premature monetary contraction can slow growth.

The Chinese government is currently facing this fiscal policy circularity problem. In an interview on June 18th with the IMF mission chief for China Markus Rodlauer, he notes that high frequency data such as retail sales, investment growth all point to moderate growth. Even thought the PMI may have faltered a little bit, it's well within historical ranges. Rodlauer takes this and makes the conclusion that there's really no need for stimulus. 

While he may be right, it is also likely that the Chinese government could fall into a fiscal circularity problem. Especially since Chinese fiscal policy has the ability to reallocate a large amount of resources, much of business is conducted on the basis of expectations of future government policy. Under these conditions, concluding that economic conditions are strong on the basis of high frequency data may cause the fiscal authority to be too sluggish in responding to a slowdown in growth.


  1. Suppose the monetary authority credibly announces that it stands ready to do whatever it takes to keep the market’s expectation of NGDP one year in the future on a steadily rising path (5% per annum, or whatever--the Sumner program). The only way in which the authority’s actions figure into the market’s expectation for NGDP is that the market *believes that this is the authority’s intention*; where, then, is the circularity? At any moment market-expected NGDP may fall slightly below or rise slightly above the objective, but immediately the authority will take appropriate action to move it back on track.

    As for the Fed’s taper talk, the problem is that the markets don’t trust the Fed—with good reason, given its performance in recent years. The Fed could have quickly counteracted the impression made by the initial taper talk, but did not do so through simple incompetence.

    I presume that markets also mistrust the Chinese monetary authority.

    Fiscal policy is not in itself worrisome, given the potential for *monetary offset*.

  2. The problem is that the Fed would have no way to know whether it should take action. Even though we talk about expectations, in the end there is a concrete mechanism from the money supply/interest rates to real economic activity. The circularity arises when the Fed takes no action because it thinks the market expectations were stable, but they were only stable conditional on Fed action. Sumner's proposal gets around this by tying the expectation to the instrument.

  3. Summer wants a prediction/futures market in NGDP-one-year-ahead, which would involve the Fed in automatic active adjustments. But even without such a market--if the Fed were going by their own in-house estimates of NGDP-one-year-ahead, based on whatever data they thought relevant--there shouldn't be a serious problem, so long as the Fed estimates were positively correlated with the market's estimates and the market trusted the Fed to be trying sincerely to stabilize its NGDP expectations. If the Fed failed to take some action that the market was relying on in forming its own estimate, as soon as the market noticed this its expectation would change, which would cause the Fed's own in-house estimates to change in the same direction (if the latter were reasonably good), which would cause the Fed to act--a bit belatedly, but still effectively.

    But I take it you agree that the Sumner program with an NGDP futures market has no circularity problem whatever.

  4. 1st of all, the Fed isn't tightening?? If the fed eased 25 bps 2 meetings in row and then didn't ease the third meeting would it be tightening? The nature of QE is considered/quantified to be an ease. Secondly there was always conjecture that the program would end beginning/mid 2014, there were even those that wanted to end the program mid 2013 when the program was initially started. Now HALF of the Fed wants the program to end by the end of this year, so it's turning to where majority of the fed will want the program done with at some point in 2014, almost regardless.
    The argument centers around efficacy and costs, and the committee must be starting to feel like efficacy is reaching its thresholds or 'tipping points'. So the process going forward is to adjust the 'policy mix' as he said clearly separate times now, which is expanded balance sheet continuing its reinvestment and maturing bond purchases, as well as using the communications channel to extend the lower for longer commitment, which again now would be an effective ease. Short term policy measurements are relying on market information that has been read/deduced in the span of 30 seconds... is that really dictating any policy??