The circularity problem is making me dizzy

Here is a recent story from

NEW YORK (Reuters) – Stocks rose on Tuesday after opening lower on weak economic data, with investors saying the data bolsters expectations the Fed will pump more money into the economy, which would support equities.

And what sort of economic data was weak?

September data showed U.S. consumer confidence fell to its lowest level since February, underscoring lingering worries about the strength of the economic recovery, while home prices dipped in July.

Let’s suppose consumers react with a lag to economic data, or suppose the survey was done early in the month.  In that case the survey might have reflected the very weak economic data coming out in August (revised GDP at 1.6%, etc) and also a weak stock market, which was partly a response to the weak data.

So let me get this straight:

1.  The markets were weak in August, causing a low consumer confidence number in September

2.  This leads investors to expect more easing by the Fed

3.  This leads to a stronger stock market

4.  This will lead to a better consumer confidence number in October

5.  Which will lead investors to fear the Fed won’t ease

6. Which will cause stock prices to fall in October

7.  Which will lead to a weaker consumer confidence number in November.

8.  And so on

Are you getting dizzy yet?  This is the so-called “circularity problem,” which occurs when the Fed tries to target market expectations.  It was discussed in 1997 in a pair of JMCB papers by Garrison and White, and also Bernanke and Woodford.

The Fed needs to be careful here.  It’s easy to say the Fed doesn’t respond to the stock market; but let’s face it, they do.  They cut rates after the 1987 crash, even though there was no sign of recession or deflation, and they announced a bond purchase program in March 2009, right after a sickening plunge in equity prices.  Make all the jokes about the stock market you want, people do see it as an important indicator of which way the economy is headed.  Even if only subconsciously.

So if the Fed were to meet in November and decide not to do QE because the market was looking up, and if the market was looking up because they expected QE in response to weak economic data, then the Fed could end up with a nasty surprise.  Something like what occurred in December 2007 and January 2008, or again in September 2008 and October 2008.  Using Wall Street lingo, they could “fall behind the curve.”

Of course none of this would be a problem if the Fed used the sort of futures targeting idea I proposed back in 1987 (or similar ideas by people like Dowd, Woolsey, Jackson, etc.)  But that’s not going to happen, so they’re going to need to be very careful in evaluating market signals.  I almost broke out laughing when I read the first paragraph of that Yahoo story–it’s a near perfect example of the circularity problem.

I worry that the Fed does not fully appreciate the circularity problem.  From the WSJ:

Under the alternative approach gaining favor inside the Fed, it would announce purchases of a much smaller amount for some brief period and leave open the question of whether it would do more, a decision that would turn on how the economy is doing. This would give officials more flexibility in the face of an uncertain recovery.

.  .  .

Markets anticipate the Fed will pull the trigger, barring some surprise turn in the economy. Economists at Goldman Sachs Group Inc. estimate the Fed will end up purchasing at least another $1 trillion in securities, and estimate that would push long-term interest rates down by a further 0.25 percentage point.

A leading public proponent of a baby-step approach is James Bullard, a 20-year Fed veteran who has been president of the St. Louis Federal Reserve Bank since 2008. He says he has made progress convincing his other colleagues to seriously consider that path.

“The shock and awe approach is rarely the optimal way to conduct monetary policy,” he says. “I really do not think it is the right way to go except in really exceptional circumstances.”

These are exceptional circumstances; we’re in a Great Recession.  Aggregate demand is expected to remain far too low to allow for a robust recovery.  The only way this dynamic can be changed is if the Fed does much more than the markets currently expect.  That means shock and awe.  It’s a pity it won’t happen.

PS. I notice that changed the wording of the article I linked to.

Update:  Here is an old post that explains why the circularity problem doesn’t occur under NGDP futures targeting.

My preferred monetary stimulus

The commenter Benjamin suggested that I supplement my “moderate” proposal for Fed policy, with what I really believe.  So here it is; I’ll just cut and paste from Bill Woolsey:

I favor some opportunistic disinflation from the Great Recession, shifting to a new, 3 percent target growth path for money expenditures, starting at the end of the Great Moderation, which I take to be the third quarter of 2008. The target for the second quarter 2010 would be $15.8 trillion, so the current value is 8.8 percent below target. The target for second quarter 2011 will be $16.3 trillion, so returning to target would require 13.4 percent growth in money expenditures [did he mean 12.4%?] over the next year. (That includes the already completed part of the year.) Of course, the targeted growth path of money expenditures would afterwards grow at 3 percent into the indefinite future.

My initial reaction was negative when I read Bill’s post, as I had just spent a lot of time criticizing opportunistic disinflation in a series of posts.  But the more I thought about it, the more I liked it:

1.  Getting back to the old 5% trend line is now a complete pipe-dream.  Given that many contracts have now been signed reflecting the new world of low NGDP, it probably isn’t even wise any longer.  After all, the Fed wasn’t promising level targeting of NGDP in 2008.

2.  I’m a bit puzzled by the numbers Bill uses, but perhaps that’s because he uses nominal final sales instead of NGDP.  I calculate the US as being about 5% below a 3% trend rate of NGDP growth, starting at 2008:2.  Let’s split the difference and assume we are now 7% too low.  In that case shoot for 10% NGDP growth next year, and 3% thereafter.  Target NGDP futures contracts.

3.  The negative associated with lower NGDP growth is the risk of liquidity traps.  But under my ideal policy there would be no zero rate bound, as we’d be targeting NGDP futures prices.  It would also eliminate the need for Josh Barro’s proposal to index taxes on capital, which is necessary if inflation is positive, but adds undesirable complexity to the tax code.

4.  To avoid the “circularity problem” identified by Bernanke/Woodford, and also Garrison/White, you’d have to let the market actually determine the setting of the monetary base most likely to produce on-target NGDP growth.  I described how in this post.

5.  I have an open mind about the exact amount of catch-up, and whether it should be spread over one or two years.  But the amount of catch-up should probably be in the 6% to 8% range.

Here’s what’s so clever about Bill’s idea.  It gives us the more rapid recovery that people like me insist is possible and desirable, and yet it lowers long term inflation toward zero, a cherished goal of the Fed hawks.  And it also eliminates any chance of future liquidity traps, which is what people like Paul Krugman worry so much about.  What’s not to like?

PS:  Just to be clear, this is my ideal proposal.  I am not officially shifting from 5% to 3% NGDP targeting, as we don’t yet have an ideal NGDP futures targeting regime in place, which would prevent zero rate traps.

Mr. Bernanke: Don’t forget about the circularity problem

This is from a recent WSJ article:

Whether the Fed makes any move next week depends in large part on economic data, particularly the government snapshot of the jobs market due Friday. Since Fed officials last met in June, data on consumer confidence and spending have softened and job data haven’t improved. But overall financial conditions have improved somewhat, with a rebounding stock market.

Officials in the Fed’s anti-inflation camp aren’t convinced the economy is slowing significantly and are wary of taking new actions. Others are eager to consider new steps to address recent signs of a slowdown and persistent high unemployment.

Fed officials aren’t yet prepared to take the larger step of resuming large-scale purchases of mortgage-backed securities or U.S. Treasurys. But they are holding open that option if the economy deteriorates. Private forecasters generally expect real GDP to grow by an annual rate of about 2¾% in the second half of 2010. If the picture deteriorates and they forecast growth falling below 2%, the Fed would be more likely to act.

It is true that the stock market has recently rallied, and I agree that this does slightly reduce the odds of a double dip.  But it is also important to think about why stocks rallied in July.  Some market observers attributed the rally to rumors that the Fed would eliminate interest on reserves, or do some more QE.  This article indicates that neither step is likely, in which case stocks could easily fall if next week’s meeting produces a disappointing outcome.

I doubt that rumors about possible Fed easing were the primary factor driving stocks higher last month, but nevertheless it is important to keep in mind the “circularity problem,” which occurs when markets are watching the Fed and the Fed is watching the markets.  If markets rallied because they expected the Fed to do something, and the Fed decides that nothing needs to be done because . . . well because the markets rallied, then we are not going to get anywhere.

BTW, the first time I saw the circularity problem discussed was in a couple papers published in 1997.  One was by Larry White and Roger Garrison, and the other was by Michael Woodford and some guy named Ben Bernanke.

I’m still trying to figure out why the WSJ doesn’t expect the Fed to do anything.  We have had about 4% NGDP growth over the past 4 quarters, which basically means we are just treading water, not recovering.  RGDP growth is expected to be about 2.75% going forward, roughly the trend rate of growth for the economy.  Assuming inflation continues to run around 1% to 1.5%, then NGDP growth will continue at 4%.  In other words:

1.  The economy has not really been recovering over the past year.

2.  The economy is not even expected to begin recovering in the second half of the year

3.  We are in the worst recession since the 1930s

4.  Fiscal stimulus will be reduced over the next year

5.  Ergo, no need for more monetary stimulus.

If my students asked me what the Fed was thinking, I would have a hard time even answering the question.  I suppose I could mumble something about inflation fears.  But then there is this from the same article:

The Fed is in a difficult spot. As Mr. Bernanke noted, inflation, now about 1%, is likely to run below the central bank’s unofficial target of 1.5% to 2% for the next couple of years. That is stoking worries of deflation, a debilitating fall in prices across the economy. Unemployment is expected to remain high even longer.

I would have thought that put the Fed in an incredibly easy spot.  Really bad recession, no sign of recovery, no additional fiscal stimulus, inflation falling well below target, worries of deflation.  Hmmm. . . . these decisions are just so difficult.