Anyone who has kept up with economic developments since the start of the year knows that the global economy has hit another pothole on the road to recovery. I am tempted to exclaim in exasperation, “Here we go again!” This week the OECD sounded the alarm, warning that global growth in 2016 will likely not exceed its 2015 level. In the face of continued weakness, the OECD has called for international action to support recovery.
What led to the OECD’s warning? A week ago Eurozone data were released showing considerably more weakness than expected. The outlook for China has suddenly become clouded. The Russian economy is following oil prices downward. And Brazil is mired in recession. India is the only BRIC — the acronym coined by Jim O’Neil for Brazil, Russia, India and China — that is growing soundly. Is it any wonder then that Larry Summers recently referred to BRIC as the “Bloody Ridiculous Investment Concept”?
Things looked so much brighter just a few months ago. So bright, in fact, that in December the Fed embarked on its long-anticipated journey back to the land of "normalized" monetary conditions. It has been “abroad,” in the land of extraordinary measures, since 2008. Make no mistake, the Fed's actions were not intended to tighten policy. In the metaphor favored by central bankers everywhere: just because you take your foot off the accelerator, it doesn't mean you are applying the brakes. The December increase in its benchmark interest rate was merely intended to reduce, in an ever-so-slightly manner, the degree of monetary stimulus in the economy. A journey of a thousand miles begins with the first step, as the old Chinese proverb goes.
The decision to increase the federal funds rate was justified, the Fed believed, by the marked improvement in the U.S. labour market, with unemployment down and, more importantly, participation rates up -- as well as signs of modest growth for wages. Those elements are good news, to be sure. But the Fed is conscious of its dual mandate when it comes to price stability and full employment. Monetary policy affects the economy with “long and variable lags,” to quote Milton Friedman’s memorable phrase. While inflation is still well below its target of 2 percent, the Fed has to base its decisions on counterfactuals — balancing where the economy would likely go without a policy change versus its path under the effects of the proposed change.
It is a decidedly-difficult task. The trick is to anticipate future actions and events that might impede progress towards your goal. A successful Formula One driver, for example, correctly anticipates the reactions of other drivers and finds the lane that will clear a path to victory. Needless to say, other sporting metaphors may apply. [1]
In some respects, however, in central banking, it is a more difficult task than in sports. In part, this is because we don’t live in the fictional world of pure economic theory of perfect foresight or rational expectations equilibrium. The Fed’s decision-makers have to act in a world of pervasive uncertainty.
Consider their dilemma: It might be helpful to think of the problem in terms of a journey. At any given time, central bankers don’t know precisely where they are. Yes, high-frequency financial market data provide real-time information on what is happening in financial markets, but data on the real economy (GDP) is only produced with a lag. Moreover, GDP numbers are subject to revision after the fact. These changes to “final” estimates are typically modest, but such revisions can be large when the economy is going through a significant transition. It is somewhat like trying to drive by looking in the rearview mirror — a feat quite possible as long as the road is straight, but considerably more difficult when there are curves ahead.
But there is often an uncertain relationship between what central bankers can control, typically the Policy Rate for inflation-targeting, and economic variables. That relationship is subject to change. And that is problematic. Central banks devote enormous time and resources estimating this “transmission mechanism.” Nevertheless, the relationship remains somewhat of a “black box.” And the simple fact is that there is always uncertainty stemming from changes in the economy, shifts in behavior, and a misspecification of their model. Yes, central bankers are human too. Lest there is any doubt of this last point, consider the fact that, apart from a basic specification of the demand for liquidity, the models used by most central banks prior to the global financial crisis, Dynamic Stochastic General Equilibrium (or DSGE), did not have well-articulated financial and credit links.
The connection between the variables that the Policy Rate affects (with uncertain effects) and the ultimate objectives (inflation and full employment) adds another layer of uncertainty. The Fed’s changes to the federal funds rate will affect investment and consumption, for example, and as a result GDP. However, the relationships between GDP and unemployment and inflation are not known with certainty and they too can change in response to shocks in the economy.
The problem for central bankers since the global crisis is that the transmission mechanism isn’t working the way it is supposed to. Imagine our Formula One driver about to overtake the lead car on a curve. The driver kicks down the clutch and changes gears. But rather than accelerate out of the turn, the car loses power. For the Fed, whose December policy action is coming under scrutiny, one change that may have affected its black box is the exchange rate and structural shifts in the global economy that have increased the correlation between the old “advanced” economies (formerly known as “industrialized”) and the emerging market economies (the BRICs, for example). In this perspective, the marked appreciation of the U.S. dollar over the past year, combined with the stalling out of BRIC motors, would explain the moderation in growth prospects.
Is this perspective correct? I don’t know; frankly, it is too early to tell. Remember, real-side data only come in with a lag. My gut tells me that the United States is less at risk than the Eurozone, where the structural problems associated with a dysfunctional quasi-gold standard and Akerlof ‘market for lemons’ banks remain. However, readers of economic history (or at least Larry Summers’ recent contribution on secular stagnation) know that Keynes used a mechanical metaphor to describe the malaise of the 1930s and the seemingly ineffectiveness of monetary policy to jolt the economy out of stagnation. The parallels between that decade of stagnation and the New Age of Uncertainty are clear and a prudent central bank might do well to observe the warning signals flashing.
[1] Wayne Gretzgy, the hockey player, is famous for not going to where the puck is, but to where the puck is going to be; successful North American football running backs intuit how and where holes will open in the defensive line and run through them; all-star baseball homerun hitters can “read” the pitcher and anticipate in the millisecond that the ball leaves the pitcher’s hand if it is a fastball, curve or slider.
