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.



23 Responses to “Mr. Bernanke: Don’t forget about the circularity problem”

  1. Gravatar of mbk mbk
    3. August 2010 at 18:11

    Scott, circularity is an interesting problem in the economy. Positive feedback, say, expectations of rise driving up prices further, or expectations of fall driving down prices further, is what makes the economy work through things like economies of scale, and compounding. A plus feeds back into an even greater plus, but it also creates self reinforcing crashes on the downside. Negative feedback, like a thermostat, when a rise leads to a dampening of the rise, and a fall to a tendency of increase, is the control factor, example, the price system in its normal condition.

    The interactions of positive and negative feedbacks are important and can be devastating, as shown in control theory and in population biology. Here you have compound growth leading to explosive positive feedback, i.e. growth, and limitations in the factor endowment of the environment leading to a negative feedback due to increasing limitation. The most important self correcting negative feedback loop in the economy is obviously the price system in the normal context of prices and production. But in the speculative context, the price system produces positive feedback (self reinforcing boom and crash). In any event, negative and positive feedbacks working together create powerful conditions for booms, crashes, and destructive oscillations, which are mathematically well studied in both population ecology and in control theory. I am always puzzled how little the feedback loop frame is used to look at macro.

    Regardless of what one thinks he should do or have done, Mr Bernanke as a decision maker is not acting as one could have thought from his previous academic writings and speeches. And this begs the question which of the following has happened: 1- he changed his mind in the normative area (why? I find this unlikely); 2- he changed his mind in the positive area – he became privy of economic facts that only his position can see (also unlikely – lots of statistics and economists out there); 3- he faces a new set of facts: political pressures, not as direct authority over him, but consensus making issues, and issues of expectations of coming pressure if he does not do this or that. Maybe so but as a well reputed academic who does not seem to be an ego driven personality, he could also just resign if he does not like the pressure.

    So maybe it is just as simple as that: like in other areas of life, once you are in the hot seat, your perspective changes, and you see new risks and pressures that previously you didn’t. Maybe he truly is worried that if he sets in a positive feedback loop in the direction of positive inflation expectations, inflation could explode in his face. For instance, were these enormous bank reserves truly unleashed as a sudden avalanche. Maybe he truly believes he is walking a tightrope.

  2. Gravatar of Benjamin Cole Benjamin Cole
    3. August 2010 at 18:15

    Another excellent commentary from Sumner. He really ought to pen an editorial for the WSJ.

  3. Gravatar of scott sumner scott sumner
    3. August 2010 at 18:27

    mbk, I suppose one’s perspective changes. But I also think he faces institutional constraints. And perhaps he was never has close to my views as I had assumed.

    Benjamin. I have (with a co-author), will they publish it?

  4. Gravatar of Gregor Bush Gregor Bush
    3. August 2010 at 19:23

    The last paragraph of the article is the most depressing – it argues that there is little support at the Fed for reducing the rate paid on excess reserves because: “That rate is already low and the Fed’s target is below that most days. The Fed wouldn’t get much benefit by pushing the rate lower…”

    Of course this completely misses the point: to stimulate AD by inducing banks to move the reserves into circulation thus creating higher expected paths for the price level. I really hope that this journalist has misunderstood what Fed officials were telling him and that this final paragraph doesn’t really reflect their thinking.

  5. Gravatar of marcus nunes marcus nunes
    3. August 2010 at 20:01

    On the “circularity problem” Poole got it first on the summer 1988 issue of the JEP in an article entitled: Monetary Policy lessons of the Recent Disinflation”

  6. Gravatar of Lorenzo from Oz Lorenzo from Oz
    3. August 2010 at 22:03

    I recently read Nigel Lawson’s 1984 Maias lecture on the policy of the Thatcher Government. A couple of things struck me. First, that it was much easier to understand because I have been reading your blog. Second, the framework of analysis the then Chancellor of the Exchequer used seemed very “Sumnerian” (rather more than the actual policy framework outlined) in that it was very much about playing to expectations.

    That the Thatcher Government’s macroeconomic strategy worked rather better than the bulk of the economics profession expected had a certain resonance too.

  7. Gravatar of tweeting tweeting
    4. August 2010 at 03:47

    Given the contradictory nature of paying interest on excess reserves, why really bother, if the newly created portion of money from QE1 isn’t leaking into circulation. QE2 isn’t likely to fare better, given banks’ ability to soak up excess reserves. Something to note is the strength of the dollar, while expectation of fiscal stimulus/deficit spending (mailing cheques, etc) had weakened usd sustantially in 2008 as measured by usd index, a flight to quality (world’s premiere trading/reserve currency) meant usd had regained much of its parity. For QE2 to work better to inflate, you better hope rest of the world doesn’t worsen much, particularly europe (US runs a bigger trade deficit with Europe than with China, and half of world daily FX trade is in eurusd). Europe is barely experiencing inflation.

  8. Gravatar of Mattias Mattias
    4. August 2010 at 04:32

    On the other hand the July rally is a bit overstated. Looking at a chart of S&P500 we can see how unremarkable this rally is. See$SPX

  9. Gravatar of tweeting tweeting
    4. August 2010 at 04:52

    Sorry, a correction to my last post – it should be that US runs a bigger trade account with Europe, not trade deficit. But the point still stands, when your biggest trade account partner is barely experiencing any inflation to be passed onto you. (US-EU 2008 639.5 bn, 2009 502.4 bn; US-China 2008 407.5 bn, 2009 365.9 bn).

    With regards to stock market July rally, it’s been melt-up in thin volume and melt-down in heavy – no conviction. In short, market has gone no where since flash crash.

  10. Gravatar of Benjamin Cole Benjamin Cole
    4. August 2010 at 07:50

    Getting an op-ed published is always a chore, but timing is definitely in your favor.
    I was a financial journalist (and still dabble) for more than 20 years (you can find two books I wrote for Bloomberg Press at Amazon. They were very successful, and sold hundreds of copies).
    It helps if the editorial is engaging–not always easy to do with economic and business topics. I would be happy to look at what you have written, and pitch to the WSJ powers that be, or the NYT. You have an exceedingly important contribution to make at this juncture.
    Sometimes just a word or two in a pitch can help–that you wrote a piece for Cato Institute for example, in the pitch to the WSJ This gives you street cred.
    For the NYT, you play up that you are a UofChicago conservative economist, but even you want a much more liberal Fed at this point in time.

    In an e-mail pitch, you get about 30 words to sink the hook.
    I can’t imagine a more timely pitch for business readers.

  11. Gravatar of Justin Justin
    4. August 2010 at 08:23

    “It is true that the stock market has recently rallied, and I agree that this does slightly reduce the odds of a double dip.”

    Scott, I’m not sure we should rely on the stock market to estimate the likelihood of a double dip recession over the next several quarters.

    The S&P rallied up to 10/9/2007 , and 2008Q1 GDP was negative.

    The S&P rallied to 9/1/2000, and 2001Q1 GDP was negative. There was also a sharp rally from early April to mid May of 2001.

    The S&P rallied to 7/16/90, and 1990Q3 GDP was flat and 1990Q4 GDP was negative.

    The S&P rallied to 2/13/80, and 1980Q2 GDP was down a massive 7.9%.

    It seems at best, a stock market rally seems to suggest – but not always indicate – that we aren’t currently in a recession.

  12. Gravatar of JimP JimP
    4. August 2010 at 08:37

    The following is a passage or two from Conrad Black’s book on Roosevelt. They have been hand typed by me and so there may be a typo or two.

    Page 264:

    Hoover had one last try at smoking out Roosevelt: he sent the president-elect a ten page handwritten letter February 8th declaring that there was now a state of alarm in the country that threatened the recovery Hoover professed to believe was in progress. Hoover wrote that what was necessary was a clear statement from Roosevelt that there would be a balanced budget whatever the cost in taxation, and that the gold standard would be defended and inflation completely resisted.

    Page 265:

    In a memorandum to Senator David Reed…..Hoover wrote that the problem was national uncertainty due to concern that Roosevelt might inflate, fail to raise taxes, have recourse to deficit financing……….

    Page 272:

    The effect of (Roosevelt’s inauguration speech) was electrifying. The long dreary years of Hoover’s pettifogging and sermonizing and evasions passed noiselessly into a despised oblivion. When Roosevelt finished his fifteen minute address, no-one doubted that a drastically new era had begun, based on ambitious goals and not Dickensian humbug and claptrap about imminent spontaneous recovery.

    Page 275:

    The basis of what went to Congress March 9 had been prepared by Hoover’s Treasury Secretary, Ogden Mills. Roosevelt was strongly urged by the urban left and the western progressive and populist members of the Congress to nationalize the banking business. He knew that any such initiative would be insane – would completely distract the administration and Congress from the underlying task of resolving the depression, would bitterly divide the politicians and public and if successful would catapult the government into the operation of a huge business for which it had no aptitude and in which it would attract infinite ill will for any loan declined or called or any rise in interest rates. He maneuvered deftly to appear a savior of the industry to the conservatives and a reformer of a flawed banking system to the nationalization advocates.

    Page 276:

    The house passed the Presidents banking bill on March 9 by a voice vote and without debate. The Senate passes it seventy three to seven after a debate of a few hours.

    Roosevelt went on the radio at 10pm eastern time Sunday March 12 to explain the banking crisis……..(He said) his legislative measure authorized the issuance of special currency banked by bank assets which was being distributed around the banking system to deal with further heavy withdrawals if these continued without forcing uneconomic liquidations of bank assets.

    (Does this count as a helicopter drop?)

    History does not repeat, but is sure does rhyme.

  13. Gravatar of Mike Sandifer Mike Sandifer
    4. August 2010 at 09:00


    Perhaps it’s worthwhile to point out that the Euro debt crisis may have really dragged things down May and early June in the US, but since the ECB promised to do its job, we’ve seen a slight recovery. Now we are subpar on our own.

  14. Gravatar of JimP JimP
    4. August 2010 at 09:13

    A mention of price level targeting on this tape – though it is then immediately and completely mis-understood by the host – who is supposed to know what he is talking about.

  15. Gravatar of D. Watson D. Watson
    4. August 2010 at 10:26

    At some point, I think we need to pull out Occam’s razor and decide that the most likely explanation is that Bernanke was replaced by an alien clone of himself, which is why he has forgotten and refuses to act on everything he wrote. 🙂

  16. Gravatar of Doc Merlin Doc Merlin
    4. August 2010 at 15:03

    “That the Thatcher Government’s macroeconomic strategy worked rather better than the bulk of the economics profession expected had a certain resonance too.”

    The macroeconomic profession has been particularly bad at actual predictions since its inception. Generally statistical models with no economics in them whatsoever (Arch, Garch, AR, Ma, MAR, VAR, etc) greatly outperform them.

  17. Gravatar of JimP JimP
    5. August 2010 at 09:50

    At last –

    A comment from a firm that actually does know what they are talking about. The Fed buys bonds from individuals, not banks, and up goes currency in circulation and up go prices.

    As the paper says:

    begin quote
    If the Fed starts buying bonds what could happen?

    Since the Fed would be devaluing the paper currency in circulation, market participants would most likely wish to store their wealth in other assets, such as gold, silver, oil, copper, stocks, real estate, etc. The mere announcement of such a program would begin to accomplish the Fed’s objective of creating an expectation of higher future inflation. The expectation of future inflation can lead to asset purchases and investing, which in theory creates inflation by driving the prices of goods, services, and assets higher. In fact, the creation of this document and your reading of it assist in the process of creating increased expectations of future inflation, which is exactly what the Fed is trying to accomplish.

    Chicken or Egg: Inflation Expectations or Inflation

    Mr. Bullard hypothesizes the current economy may need rising inflation expectations to come first, which in turn would help create actual inflation since it would influence the buying and investing habits of both consumers and businesses. If you feel the Fed will “do whatever it takes” to create inflation, you may decide you need to protect yourself from inflation by investing in hard assets, like silver and copper. Your purchases of hard assets would help drive their prices higher. The mere perception of the possible devaluation of a paper currency can change the buying and investing patterns of both consumers and businesses.
    end quote

    Maybe Bernanke understands this as well as this firm does. If he doesnt, maybe Obama could remind him.

  18. Gravatar of Luis H Arroyo Luis H Arroyo
    5. August 2010 at 10:35

    Scott, As you know, I decidely don´t agree with an energic reaction from the FEd now. A jump in the NGDP fron 2,8% to 4% (measured in % on same quarter year ago) and the improvement of other indicators (or not clear deterioration)don´t mean for me a risk of inmediate fall of the economy to an accute depression.
    I see as special positive sign the huge increase in corpotrate profits in the second quarter, which is propably the main cause of recent optimism in WS.
    All these excelent corporate result will surlely have an upward effect in real investment, as it is yet evident in the capital expenditure in the QII. That probably will put in circulation the $ 1 trillion treasured in bank & corporate. The employment probably will follow.
    In these circunstances, and with a government which is searching to aprove more fiscal aid, there is much less risk for a Central Banker wait and see that any other decision. The time to loose is off, I think.
    I´m not 100% sure, evidently. But I feel the doubts on US economy are over.

  19. Gravatar of JimP JimP
    5. August 2010 at 11:10


    Well, as for me, I think that those gigantic profits mean that the plutocratic class is fighting the class war very successfully. I did not think Obama represented that class. That is for the Republicans to do, in my opinion.

  20. Gravatar of Doc Merlin Doc Merlin
    5. August 2010 at 13:35

    And the new financial reform bill exempts the SEC from Freedom of Information Act requests, if that isn’t regulatory capture… I don’t know what is.

  21. Gravatar of marcus nunes marcus nunes
    5. August 2010 at 16:21

    While Scott is on holiday, reading on the “deconstruction” of Krugman is fun.

  22. Gravatar of Luis H Arroyo Luis H Arroyo
    5. August 2010 at 22:51

    JimP, ok, but I believe in the stars war,more than any other.

  23. Gravatar of scott sumner scott sumner
    6. August 2010 at 05:36

    Gregor, I had the same thought. They think monetary policy is about interest rates, whereas it is actually about the supply and demand for base money.

    Marcus, Thanks, In economics, there is always someone earlier.

    Thanks Lorenzo. That’s a very good essay.

    Tweeting, I agree that interest on reserves is a bad idea. Monetary stimulus can work here, however, regardless of what the rest of the world does–it’s not a zero sum game.

    Mattias, Good point.

    Thanks Benjamin, This particular op-ed was actually mostly written by my co-author. I hope it is accepted.

    Justin, I agree that there are many false signals, but it is better than just flipping a coin. That’s why I merely said “slightly reduce the odds.”

    JimP, Thanks. Studying the Depression helped me to better understand Great Recession. There are many parallels.

    Mike, I agree. The debt crisis increased the demand for dollars, which slowed the recovery. But once that occurred, and inflation expectations started falling, then the Fed needed to take affirmative steps, even if the initial shock became less severe. It has not done so yet.

    JimP, I loved that John Makin link. Thanks.

    D. Watson, I think you have finally got it right.

    Doc Merlin, I agree about the econ profession.

    JimP33, It’s good that the message is starting to circulate.

    Luis, The markets don’t agree with you. They continue to forecast sub-par inflation. We need much faster nominal growth. The level of stock prices is still rather low, despite the rally last year.

    Marcus, Thanks, the Krugman piece was amusing.

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