What Does the Fed Know that Nobody Else Knows?

When it comes to the financial and economic future, everybody is myopic. Nobody can see clearly. That includes the Federal Reserve.

As François Villeroy de Galhau, the Governor of the Bank of France, recently said in a brilliant talk, central banks are subject to four uncertainties. These are, in my paraphrased summary:  

1) They don’t really know where we are.

2) They don’t know where we are going.

3) They are affected by what other people are going to do, but don’t know what others will do.

4) They know there are underlying structural changes going on, but don’t know what they are or what effects they will have.  

Yet it appears that central banks usually feel the urge to pretend to know more than they can, in order to inspire “confidence” in themselves, and to try to manage expectations, while they go on making judgments subject to a lot of uncertainty, otherwise known as guesses.

A refreshing exception to this pretense was the speech Federal Reserve Chairman Jerome Powell gave in last August at the annual Jackson Hole symposium, 2018. He reviewed three key “stars” in monetary policy models: u* (“u-star),” r* (“r-star”) and ϖ (“pi-star,”), which are respectively the “natural rate of unemployment,” the “neutral rate of interest,” and the right rate of inflation.  None of these are observable and all are of necessity theoretical, so in a clever metaphor, Powell candidly pointed out that these supposedly navigational stars are actually “shifting stars.” Bravo, Mr. Chairman!

Let’s consider this question: What does the Fed know that nobody else knows? Nothing.

Can the Fed know what the right rate of inflation is? No. Of course, it can guess. It can set a “target” of steady depreciation of the dollar at 2% per year in perpetuity. Can it know what the long-term results of this strategy will be? No.

Moreover, nobody knows or can know what the right interest rate is. That includes the Fed (and the President). Interest rates are prices, and government committees, like the Federal Open Market Committee, cannot know what prices should be. That (among many other reasons) is why we have markets.

The Wall Street Journal recently published an article by James Mackintosh, “Fed Is Shifting the Goal Posts, and Investors Should Care.” With shifting goalposts or shifting stars, the Fed cannot know where they should be, but investors should and do indeed care very much about what the Fed thinks and does.

This is because, as we all know, the Fed’s actions or inaction, and also, financial actors’ beliefs about future Fed actions or inaction, can and do move prices of stocks and bonds substantially. Indeed, the more financial actors believe that Fed actions will move asset prices, the more it will be true that they do.

Mackintosh discusses whether the Fed’s inflation target will become “symmetric”—that is, the target would change into an average of periods both over it and under it, rather than a simple goal. Thus, sometimes “inflation above 2% is as acceptable as inflation below 2%.” Ah, the old temptation of governments to further depreciate the currency never fades for long.

“Goldman Sachs thinks the emphasis on symmetry in the inflation target is already influencing long-dated bonds,” the article reports, and opines that the change could have “big implications for markets,” that is, for asset prices. That seems right.

But the 2 percent inflation, whether as an average or as a simple goal, “isn’t up for debate.” Why not? The Humphrey-Hawkins Act of 1978, the same act that gave the Fed the so-called “dual mandate” which it endlessly cites, also set a long-term goal of zero inflation. What does the Fed think about that provision of the laws of the United States?

A true sound money regime has goods and services prices which average about flat over the long term. But being prices, they do fluctuate around their stable trend. The Fed, like other central banks, is in contrast committed to prices which rise always and forever. Discussing which of these two regimes we should want would focus consideration on where the goalposts should be.

Mackintosh worries that there may be a “loss of faith in the Fed’s ability.” On the contrary, I think a lack of faith in the Fed’s ability is rational, desirable, and wise.

Reader Discussion

Law & Liberty welcomes civil and lively discussion of its articles. Abusive comments will not be tolerated. We reserve the right to delete comments - or ban users - without notification or explanation.

on May 08, 2019 at 10:18:57 am

An important point you make: "A true sound money regime has goods and services prices which average about flat over the long term."

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Ron Phillips
on May 08, 2019 at 10:22:21 am

A very accurate assessment of the FED's inability to know what is going on. If the FED had any sense they would allow the Market to set the Interest Rates, yes, even the FED FUNDS RATE. This would allow rates to be a direct product of the Law of Supply and Demand; when money is plenty, rates would decline and when money is in short supply, rates would increase. The FED could oversee this process and when there are strains on one side or the other, they could step in and moderate the current move. Oh, this seems way too simple and we wouldn't need the Bureaucratic host of Phd. Economist on staff.

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on May 08, 2019 at 10:24:24 am

We know from long ago that Central Banks do not know more things than "markets". However they were created to gather as much information as possible and to push whatever levers they have to stabilize the average growth of prices, output and employment. Given the number of recessions and crisis that we have seen since the irruption of Central Banks (late XVII Century), we might conclude that they have been a failure. But there's no way to know how many recessions and crisis the might have avoided...! I have been very critical of Alan Greenspan's Fed decisions after 2001 that ultimately led to the 2008 failure, but that doesn't takes me to propose the elimination of Central Banks... Let's trust in their capacity to learn from experience and research, and to avoid further mistakes.

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Martín Lagos
on May 08, 2019 at 10:36:09 am

"A true sound money regime has goods and services prices which average about flat over the long term."

That's incorrect, and fatally so. Positing a stable (market determined) supply of a commodity money, the natural trend over time is for all prices to FALL as price variability, productivity enhancements and market competition drive returns to capital towards a common level.

An INFLATIONARY monetary scheme - such as was conducted by the US Fed during the 1920s - will result in flat average prices by masking the gains from productivity, and result in the eventual "bust" - just like the depression of 1929.

From 1870-1913, the US was on a gold-coin standard during which except for the occasional unexpected gold strike, the money supply was stable (as defined above). This was a period of great prosperity for the expanding US population as the productivity gains from industrialization drove market prices down and real incomes up.

A monetary regime that seeks "stable average prices" over the long run is a scheme to rob the masses of their prosperity...

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OH Anarcho-Capitalist
on May 08, 2019 at 11:29:57 am

The Dunning-Kruger effect run amuck. Add a dose of confirmation bias and chaos ensues. I remember the 70’s.

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on May 08, 2019 at 13:46:29 pm

For those of you who are smarter than I am, try reading Jeffrey Snyder at Alhambra Partners (he is also referenced at times on RCPolitics). From all I can tell, he has quite an astute take on the (cluelessness of) the Fed. He is beyond a challenge for my understanding, but I suspect he is definitely on to something.

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John in Austin
on May 10, 2019 at 11:45:09 am

Thank you, Mr. Pollack, for pointing out the long-term goal of zero inflation in the Humphrey-Hawkins Act. It's time for the Fed to carry out that responsibility. I'm 80 years old, and the price changes due to inflation during my lifetime are ridiculous. Having a dollar in your pocket used to mean something; now it won't even buy a cup of coffee.

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Carol Simon
on May 10, 2019 at 13:39:41 pm

Just a question: where is the ``long-term goal of zero inflation'' in the Humphre-Hawkins 1978 Act? As a matter of curiosity, I looked it up and, in Section 2 (i) I find:

``The Congress further declares that it is the continuing policy and responsibility of the Federal Government, in cooperation with State and local governments, to use all practical means consistent with other essential considerations of national policy to provide sufficient incentives to assure meeting the investment needs of private enterprise, including the needs of small and medium sized businesses, in order to increase the production of goods, the provision of services, employment, the opportunity for profit, the payment of taxes, and to reduce and control inflation. ''

``Reduce and control'' inflation is a far cry from a hard and fixed zero-inflation rule. We also have a temporary goal of 3% yearly, admittedly as a``medium term'' goal, Sec 4 (b). Finally, Section 5 (b) states

``(b) In choosing means to achieve the goal for the reduction of unemployment and choosing means to achieve the goal of reasonable price stability, those means which are mutually reinforcing shall be used to the extent practicable."

Again, not really a clear commitment to long-term zero inflation. Of course, in this and the previous century, essentially no country has had long-term zero inflation to my knowledge, so the failure of the US in this respect is, perhaps, neither surprising nor a reason for dismay.

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F. Leyvraz
on May 11, 2019 at 12:05:28 pm

The Humphry-Hawkins 1978 Act, Sec. 104, Sec. 4(c) (2) "...each succeeding Economic Report shall have the goal
of achieving by 1988 a rate of inflation of zero per centum..."

Always, of course, dependent upon not interfering with the rate of employment.

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Carol Simon

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