Jeff Horwich serves as interlocutor in “Jón Steinsson interview: Forward guidance, the state of macro, and how the economy is like a rumbling volcano” (Federal Reserve Bank of Minneapolis, December 19, 2022). There are lots of interesting comments about how to do empirical cause-and-effect work in macroeconomics, whether Federal Reserve policy announcements move markets because of the policy change itself or because of what the policy change reveals about the Fed’s underlying opinion about the economy, why inflation expectations seem so sticky at present, whether members of the Fed Board of Governors should be giving more or fewer public speeches, and other issues. Here are a couple of comments that caught my eye:
The fundamental challenge of limited data in studying macroeconomics
We economists often get criticized for our inability to predict how things are going to turn out. I think people don’t fully appreciate the fact that we’re trying to predict something that is not only pretty complicated, but we’ve only seen very few instances of this thing we’re trying to predict. In the United States in the post-war period, we’ve seen maybe a dozen recessions. We’ve seen inflation really rise three or four times. This is a little bit like a weather forecaster who’s trying to predict the weather but has only ever seen 12 storms.
Now I’m overdoing it a little bit of course; there are many countries and we can learn from other countries. But countries are correlated. And the total number of events in terms of recessions and increases in inflation that we’ve seen—maybe on the order of a few hundred. It’s a fairly modest amount of data that we’re using to make inference about something extremely complicated. And recessions are heterogeneous: The COVID recession is very different from the Great Recession, which is very different from the Volcker recession.
There’s a similar thing going on in Iceland at the moment, because there’s this volcano that is rumbling and actually has erupted twice in the last two years. But this volcano hadn’t erupted for 800 years. The volcanologists are on TV every day being asked to predict when the next eruption is going to happen, how long is the eruption going to last, is it going to get bigger, is it going to get smaller.
I felt like it was very similar to us economists who are being asked the same questions about events that only happen every decade or so. I think the public is more understanding of the volcanologist than they are of the economist in this respect! I wanted to draw that distinction, because I think it’s important for people to understand that the amount of data we have to go on is very finite, and that’s playing a role in why we can’t forecast everything perfectly.
Why Federal Reserve decisionswill and should surprise the markets
The meetings [of the Federal Open Market Committee] only happen every six weeks or so. And in between those meetings there are all kinds of announcements and new data that are coming in. And for each of these, the market has to think about how it thinks the Fed is going to react to that new piece of data.
If we lived in a world where the Fed’s “reaction function”—the way it reacts to new information—was completely known to everybody, then there would never arise a discrepancy between what the market thinks the Fed thinks, and what the Fed actually thinks. But we don’t live in that world. I’d be surprised if the members of the FOMC could even, in their mind, fully articulate their reaction function. It’s just too complicated to do.
Differences between the market and the Fed are going to compound over those six weeks. At the next meeting, the Fed is going to want to tell the market again: “This is actually what we think, this is how we view the incoming data over the last six weeks, and this is what we think we’re going to do going forward.”
It’s inevitable that the Fed is going to surprise the market, and it needs to be willing to surprise the market. Otherwise, it’s putting the market in the driver’s seat of monetary policy—which doesn’t actually even conceptually make any sense because it’s circular, but certainly is not good policy. In that sense, I think it’s important that the Fed not be afraid of surprising the market.