Federal Reserve officials like to say their policy course is “data dependent.” That sounds cautious and smart. But how could their choices not be data dependent?
Of course, they do look at data, and lots of it. The real question is: are they looking at the right data? If it is the right data, is it accurate?
Unfortunately, our policymakers often rely on data created by outdated models that are based on past performance. Worse, that data is often some kind of third derivative model, with all sorts of assumptions that are quite a bit of ways removed from the actual data.
In their defense, the amount of data at the “meta-data” level is simply too large for any human being to process in any coherent manner. The data has to be systematized, again, based on assumptions.
And it’s not computers that make those assumptions. It’s human beings, doing the best job they can. That means our “data-dependent” Fed officials use models based on assumptions they make themselves with the hope that the derived data will tell them what assumptions they should make about the data.
Whatever your economic and political ideology, we can all agree it is a big problem.
Here’s a common narrative in the mainstream media these days. I made this up, but similar thoughts prevail.
US growth is finally taking off after years of stimulus. We’re near full employment and wages are starting to rise. Consumers are opening their wallets just as tax cuts and deregulation embolden businesses to expand. At the same time, we are hitting resource constraints that have the economy close to maximum output. The resulting inflation fear is pushing interest rates higher and taking some froth out of the stock market.
A lot of people agree with this, especially those talking to the mainstream media. The problem with that narrative is that they are assuming unproven facts. Two in particular:
- We’re near full employment
- The economy is close to maximum output, or “Potential GDP.”
Are those right? How do we know? How do we even define full employment and maximum output? This isn’t like sticking a thermometer in your holiday prime rib to see how it’s cooking (which if you are serious cook/chef you absolutely must be doing).
I thought about this last week when I read a Washington Post op-ed by Jared Bernstein. Jared was the chief economist for Vice President Joe Biden and now works at a left-of-center Washington think tank.
We are on quite different economic and political policy ground so I wouldn’t normally quote him. But we also have some common ground, and I think it’s important to note.
And for the record, more and more economists of all stripes and backgrounds are coming around to this very same view. But Jared does a particularly good job in framing the issues.
Here’s an excerpt from his op-ed. (The bold print is mine.)
Recent events have exposed a hole in the middle of economists’ knowledge of key economic parameters: We know neither the unemployment rate at full employment nor the potential level of gross domestic product (GDP).
That hole is particularly important right now. The combination of the deficit-financed tax cut and the new spending bill are pumping hundreds of billions into an economy that many argue is already at full employment. If so, then much of this extra spending won’t lead to new investment, jobs or higher real pay. When the economy’s human and capital resources are fully utilized (meaning actual GDP is equal to potential GDP), fiscal stimulus just generates inflation and higher interest rates. Even if the extra demand might create some wage pressure, it will be met with higher inflation, so real wages — the paycheck’s actual buying power — won’t change at all.
The problem is that those making that argument are implicitly asserting that they know that the “natural rate of unemployment” — the lowest rate consistent with stable inflation — is roughly equal to the current unemployment rate. That is, they believe we’re at full employment. But the truth is they have no way of knowing that, and one key indicator — inflation — suggests they may be wrong.
Jared and I are likely to be at odds on what policies the data suggest. But we can’t even have that argument until we agree what the data say and mean. We don’t. We have anecdotes and hints, at best.
This is insane when you think about it. Economists are reaching conclusions, and policymakers are making decisions, based on derivatives of invisible derivatives.
Sound crazy? Yes, but it’s happening.
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