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Vol. 30 Wint BakDecemBer 28, 2012
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(October 5, 2012) Dollar bills willtumble from the digital presses un-til the labor market gets a pulse. Onlythen will the very same dollars be magi-cally caused to disappear. In this way,pledges the Bank of Bernanke, therewill be no unscripted inflation and nounsightly bubbles, only a controlled,2%-per-annum rise in the general pricelevel, as defined. It will be as if quanti-tative easing, parts one, two and three,never happened.Now begins an essay in doubt andspeculation. We doubt that the FederalReserve will recognize the moment atwhich to backpedal, and we speculatethat the future will bear no obvious re-semblance to that version of the futurethat the Fed today makes bold to fore-cast. Hold on to your hats is the execu-tive summary of the
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credit andinterest-rate forecast; details—particu-larly with respect to the new risks con-fronting investors in mortgage real estateinvestment trusts—to follow.On Sept. 13, the Federal Open Mar-ket Committee pledged to purchase$40 billion of mortgage-backed secu-rities each month until the Americaneconomy does what its governmenttells it to do. “Even after the economystarts to recover more quickly, evenafter the unemployment rate beginsto move down more decisively,” saidthe chairman in the press conferencefollowing the announcement of QE-unlimited, “we’re not going to rush tobegin to tighten policy. We’re going togive it some time to make sure the re-covery is well established.”“Well established” by the Fed’s ownlights—but how bright is that illumi-D.C., on Jan. 10, 2008. “The FederalReserve is not currently forecasting a re-cession,” he said, one month into whatturned out to be the Great Recession.In November 2008, Queen Eliza-beth asked why economists had failedto predict the biggest cyclical event of their lives. In July 2010, the Committeeon Science and Technology of the U.S.House of Representatives sought an-swers to the same question, particularlyas it touched on the Fed’s econometricmodels: Are they any good at all?“The dominant macro model hasfor some time been the Dynamic Sto-chastic General Equilibrium model, orDSGE, whose name points to some of its outstanding characteristics,” notedthe committee in setting the scene forthe inquest. “‘General’ indicates thatthe model includes all markets in theeconomy. ‘Equilibrium’ points to theassumptions that supply and demandbalance out rapidly and unfailingly,and that competition reigns in marketsthat are undisturbed by shortages, sur-pluses, or involuntary unemployment.‘Dynamic’ means that the model looksat the economy over time rather than atan isolated moment. ‘Stochastic’ corre-sponds to a specific type of manageablerandomness built into the model thatallows for unexpected events, such asoil shocks or technological changes, butassumes that the model’s agents can as-sign a correct mathematical probabilityto such events, thereby making theminsurable. Events to which one cannotassign a probability, and that are thustruly uncertain, are ruled out.”As for the beings who inhabit theworld of DSGE, they are unlike anynation? Let us review the evidence.“There are some straws in the windthat housing markets are cooling a bit,”Chairman Bernanke told Congress onFeb. 15, 2006. “Our expectation is thatthe decline in activity or the slowingin activity will be moderate; that houseprices will probably continue to rise butnot at the same pace that they had beenrising.” Since February 2006, houseprices have declined by 31%.Bernanke was back before Congresson March 28, 2007. Yes, house priceshad begun to weaken—they were downby 1% from the peak. “At this juncture,however,” he testified, “the impact onthe broader economy and financial mar-kets of the problems in the subprimemarket seems likely to be contained.”The chairman opined on the econom-ic outlook before the Women in Hous-ing and Finance and the ExchequerClub Joint Luncheon in Washington,
Calm before the storm
“Well, thank you, Mr. Market!”
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you might meet on the subway. Clair-voyant and immortal, they “see to theend of time and are aware of anythingthat might possibly ever occur, as wellas the likelihood of its occurring,” asthe committee dryly noted. Thus, the“DSGE model excludes from the mod-el economy almost all consequentialdiversity and uncertainty—characteris-tics that in many ways make the actualeconomy what it is.”What, then, did the economists haveto say for themselves? “A thought-ful person,” responded MIT professoremeritus and Nobel laureate RobertSolow, “faced with the thought that eco-nomic policy was being pursued on thisbasis, might reasonably wonder whatplanet he or she is on.”But the chairman expresses no suchcuriosity. “I would argue,” said Ber-nanke at Princeton University, his oldstomping ground, on Sept. 24, 2010,“that the recent financial crisis was moreof a failure of economic engineering andeconomic management than of whatI have called economic science.” Hereadily admitted that the DSGE modelshad failed to predict the smashup. Andneither “did they incorporate very easilythe effects of financial instability.”But that did not mean, Bernankecontinued, that the “workhorse new-Keynesian” was irrelevant or irredeem-ably flawed. “Economic models,” saidthe chairman, “are useful only in thecontext for which they are designed.Most of the time, including during re-cessions, serious financial instability isnot an issue. The standard models weredesigned for these non-crisis periods,and they have proven quite useful inthat context. Notably, they were part of the intellectual framework that helpeddeliver low inflation and macroeconom-ic stability in most industrial countriesduring the two decades that began inthe mid-1980s.” In so many words, Ber-nanke described an analytical divisionof labor. He and his central banking col-leagues will see to the forecasts involv-ing low inflation and smooth sailing.Typhoon warnings, they leave to others.Naturally, the typhoon specialistsmake their share of mistakes (we speakfrom personal experience). Many a fore-cast storm never happens. But at leastthe storm trackers’ analytical frameworkacknowledges the possibility of turmoil,upset, temporary mass delusion and oth-er such normal occurrences in the finan-cial and economic life on planet Earth.“[I]f a model doesn’t include abnor-mal times as a special case of normaltime,” David C. Colander, professorof economics at Middlebury College,helpfully noted in a paper he preparedfor the January 2011 meeting of the Al-lied Social Sciences Association, “andprovides no way of distinguishing nor-mal times from abnormal times, thenthe model cannot serve as your funda-mental scientific model. If that is thebest model one has, it is best to admitthat one doesn’t have a firm scientificunderstanding of what is going on, andto give up the pretense of fundamen-tal science.”In New York on Sept. 19, Richard W.Fisher, president of the Federal ReserveBank of Dallas, confessed that nobodyat the Fed—neither the staff, nor thebrass—really knows what’s “holdingback the economy”; to that extent, Fish-er would seem to concur with Colander,one of the few senior monetary officialsto so dissent. The personnel of the Bankof Bernanke mainly toe the chairman’sline. Especially do such interest-ratesuppressing and money-spinning busy-bodies as Charles L. Evans and WilliamC. Dudley, presidents, respectively, of the Fed’s Chicago and New York out-posts, cling to the doctrine that the man-darins know best.It makes all the difference in invest-ing that the mandarins are just as con-fused as the rest of us. But adherents of the Bernanke doctrine are, in fact, disad-vantaged in comparison to the averageCharles Schwab customer. Practitionerswhom Mr. Market has taken to schoolknow better than to think they can pre-dict the future. Rare is the Ph.D. withpractical instruction in the field of mar-gin calls, client redemptions or unsightlydrawdowns. It is easier to believe thatone can forecast coming events whenone hasn’t been punished for trying.“A great deal of state-of-the-art analy-sis—done both inside and outside of theFed—indicates that the severe downturnof 2008-09 was mainly the result of a largedrop in aggregate demand which left theeconomy operating below its potential,”said Evans in a Sept. 18 speech at AnnArbor, Mich. “Research also shows thatbetter and more accommodative policieshave the power to reverse these setbacksand raise employment, output and in-comes. In other words, more accommo-dative policy… can deliver these betteroutcomes without generating inflationthat is significantly higher than the Fed’slong-run goal of 2%.”Economic research “shows” manythings, though it proves precious few.Either today’s “nontraditional” mone-tary policy is inherently inflationary, orit’s only potentially inflationary. Eithera fast-rising price level (say, 4% to 5%measured year-over-year and sustainedfor more than just a few months) isbaked in the cake of QE, or it’s contin-gent on the return of full employment.Or, perhaps the choice is not betweeninflation and stability but among infla-tion, stability, debt deflation, depres-
-9-6-30369121518%-9-6-30369121518%
6/123/993/893/793/693/593/49
Find the correlation
output gap* (left scale)vs. change in consumer price index (right scale)
*output gap is difference between potential and real GDPsource: Federal Reserve Bank of St. Louis
o u t p u t g a p
y e ar - o v er - y e ar CP I I n d ex
CPI:1.7%output gap:-5.9%
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sion and hyperinflation. Anyway, inbetween the lines of Evans’s argumentruns the unmistakable message: “Wedon’t worry about inflation. Therefore,you shouldn’t.”Disputing what we take to be theFed’s bedrock assumption about therelationship between inflation, on theone hand, and economic “slack,” on theother, we do worry. Go ahead and test, ascolleague Evan Lorenz has done, for thecorrelation between the year-over-yearchange in the CPI and the gap betweenpotential and real GDP (as calculated bythe Congressional Budget Office). You,like he, will find that since 1949 the twodata series are not only not positivelycorrelated, they are slightly negativelycorrelated (minus 0.03). They are statis-tical ships in the night.To err is human. To persist in erroris also human, if regrettable. To persistin error on the authority of “state-of-the-art” econometrics is the salient intellec-tual error of the stewards of the Ph.D.standard, the monetary system tempo-rarily in place worldwide pending resto-ration of the true gold standard. Chair-man Bernanke, an economics Ph.D. outof central casting, exhibits the weaknessof his type by clinging to simplistic no-tions of monetary cause and effect.Thus, in attempting to predict the con-sequences of the new mortgage-backed-securities policy (the consequences theyhoped for, not the ones they didn’t),he held forth at the post-FOMC pressconference last month as follows: “Theprogram of MBS purchases should in-crease the downward pressure on long-term interest rates more generally, butalso on mortgage rates, specifically,which should provide further supportfor the housing sector by encourag-ing home purchases and refinancing.”Maybe all of that “should” happen (orshouldn’t; one might let the market de-cide instead, which is another subject).The spread between the 30-year con-forming mortgage rate and the yield onFannie Mae-issued MBS has increasedby eight basis points to 1.43% since theFed’s Sept. 13 announcement. Over thelast 15 years, this spread has averaged0.56%. Then, again, notes Lorenz, aMay 21 bulletin from the San FranciscoFed predicted just that. There was, theSan Francisco analysis said, a “weakerlink between MBS yields and primarymortgages” owing to the consolidationof banks and the post-crisis culling of mortgage originators.So—yes—the Fed is no monolith.And Bernanke is no Dear MonetaryLeader. The Federal Open MarketCommittee is, indeed, a committee.Neither is Bernanke immortal, nor histerm as chairman perpetual. It expireson Jan. 31, 2014, from which it followsthat Bernanke is personally unable toguarantee the pledge of the FOMCto hold the Fed’s policy rate at zero toone-quarter of one percent through themiddle of 2015.Seeking a second term in 2010, Ber-nanke found himself opposed by 30senators, the most to say “nay” to anycandidate for the Federal Reserve chair-manship since the Senate began votingon that question in 1978. Maybe, then,two hitches will suffice. But who wouldfollow? If Obama defeats Romney, thenod might go to a candidate even moreradical, monetarily uninhibited andmodel-struck than the former chairmanof the Princeton economics department:William Dudley or Charles Evans, per-haps, or even Janet Yellen. Vice chair-man of the Fed, Yellen is every bit thechairman’s match in monetary open-handedness. “I am convinced,” shesaid in June, “that scope remains forthe FOMC to provide further policy ac-commodation either through its forwardguidance or through additional balance-sheet actions.” A Romney victory wouldshine the monetary spotlight on GlennHubbard, the Republican’s economicadvisor. Recall, however, Hubbard’shead-scratching assertion in August thatBernanke is “a model technocrat” whoshould “get every consideration” for a
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