Fed Confused Reality Doesn't Conform To Its Economic Models, Shocked Its Models Predict "Explosive Inflation"

Tyler Durden's picture

Below are several excerpts only the brains of those practicing the world's most useless profession (and we are very generous with that assessment) could possibly come up with, in attempting to explain the shocking outcome of reality continuously refusing to comply with their exhaustive and comprehensive Dynamic Stochastic General Equilibrium (DSGE - don't worry: it sounds complicated - it must be very serious and important, and be thus very credible and good at predicting stuff; it is neither) models.

  • With short-term interest rates at the zero lower bound, forward guidance has become a key tool for central bankers, and yet we know little about its effectiveness. Standard medium-scale DSGE models tend to grossly overestimate the impact of forward guidance on the macroeconomy—a phenomenon we call the “forward guidance puzzle.”
  • New Keynesian DSGE models following the work of Christiano et al. (2005) and Smets and Wouters (2007) are in principle well suited to study the e ffects of forward guidance
  • While the literature has provided strong theoretical justi cations for the use of such forward guidance (e.g., Eggertsson and Woodford (2003)), the evidence on the quantitative eff ects of such a policy tool on the macroeconomy is scarce
  • Empirically, Gurkaynak et al. (2005) and more recently Campbell et al. (2012) found strong evidence that FOMC announcements move asset prices. Yet when Campbell et al. try to assess the impact of exogenous anticipated changes in monetary policy on the macroeconomy, they find that this has the opposite sign than expected, highlighting these identi cation challenges.
  • Given that policymakers seldom if ever experimented with forward guidance this far in the future, there is little data to guide them.
  • The problem, however, is that these DSGE models appear to deliver unreasonably large responses of key macroeconomic variables to central bank  announcements about future interest rates (a phenomenon we can call the "forward guidance puzzle")

It gets better:

  • In general it will always be hard, if not impossible, to test the predictions of DSGE models by looking at the outcome of policy counterfactuals such as the ones in our paper: even if the counterfactual is implemented, this will not occur in a controlled environment.
  • Nonetheless, we argue that counterfactuals like the one performed here are useful for policy makers in order to quantify the potential e ects of their policies, particularly when alternative approaches are lacking as is the case here.

The problem is that the results the Fed's own models predict, fail to comply with the resultant reality:

  • Our proposed solution to the "forward guidance puzzle" is based on the realization that the apparently straightforward experiment "let us fix the short term interest rate to x percent for K periods" has implications for the short term rate that go well beyond the K-th period in medium scale DSGE models.
  • As a consequence, these counterfactuals appear to have an over-sized e ffect on the macroeconomy.
  • We view the implications of these experiments of short term interest rate in the far future as incredible. They are at odds with both common sense and the empirical evidence of the eff ects of announcements

Yes, it is ironic that the Fed is talking about "common sense", we know. But the absolute punchline you will never hear admitted or discussed anywhere else, and the reason why the Fed can no longer even rely on its models is that...

  • Carlstrom et al. show that the Smets and Wouters model would predict an explosive inflation and output if the short-term interest rate were pegged at the ZLB (Zero Lower Bound) between eight and nine quarters. This is an unsettling fi nding given that the current horizon of forward guidance by the FOMC is of at least eight quarters.

In short: the Fed's DSGE models fail when applied in real life, they are unable to lead to the desired outcome and can't predict the outcome that does occur, and furthermore there is no way to test them except by enacting them in a way that consistently fails. But the kicker: the Fed's own model predicts that if the Fed does what it is currently doing, the result would be "explosive inflation."

You read that right: if Bernanke does what he not only intends to do but now has no choice but doing until the bitter end, the outcome is hyperinflation. Not our conclusion: that of Smets and Wouters, whoever they are.

And these are the people who are now in charge of everything.

Full paper from the NY Fed:

 

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knukles's picture

Thus, another faulty model. 
Pay no attention, cast it aside.
Use Paul Krugman instead.
All will be well in NeverNeverLand

no taste's picture

Five charts say it keeps getting worse.

Enjoy the bread and circuses with tonight's "debate".

http://howstupidare.blogspot.com/2012/08/how-stupid-are-americans.html

CClarity's picture

What will we distract Americans with when hyperinflation gets going in USA?

Looks like Iran has asked ally Syria to smack Turkey as a distraction to Iranian currency collapse.  Or . . . Turkey sees an opportunity to push back at Syria knowing Iran cannot afford to support Syria right now.  But that's a dangerous assumption.  If the currency is collapsing, Iran will just go all in.

What possibilities do you see?

icanhasbailout's picture

I'm shocked - SHOCKED! - that there is gambling going on in this establishment.

 

or should that be "there is no hyperinflation in Baghdad"?

The Alarmist's picture

The Models are not wrong ... we obviously need to re-examine reality.

cranky-old-geezer's picture

 

 

Models say exactly what they want to see.

Currency printing and resulting inflation is how they're looting America, stealing everybody's wealth the silent way, giving it to Wall Street banks and the government, exactly what Fed's true purpose is.

It's what they want.  It's the plan.  Loot the nation and give it to Wall Street and the government.

Helping the economy recover is just a cover story.  They don't give a shit about the economy nor the American people.  If that isn't abundantly clear by now, you've been sleeping.

Bananamerican's picture

"the Smets and Wouters model would predict an explosive inflation and output if the short-term interest rate were"pegged at the ZLB between eight and nine quarters"

 

I need a drink....

This must be the middle class version of "models and bottles"

Pinto Currency's picture

 

This report is not a surprise to the Fed; it may be a surprise that the report got published but perhaps it is just time.

 

In fact this is a standard central bank policy called an "inflation surprise" and it gets rid of debt by inflating it away.

Richard Chesler's picture

They should try plugging fraud and corruption into their model. Then it'd all click.

Desert Irish's picture

Geography wasn't your best subject was it....

Hint: Tehran

nmewn's picture

Don't blame the student...blame the teacher.

SilverIsKing's picture

Let me introduce you to Baghdad Bob's young cousin, Tehran Ted.

Tehran Ted says: "we have no inflation but we do have skittles shitting Unicorns and candy rainbows."

nmewn's picture

No ones ever gonna get that Ahmadinejad social reference...lol.

"In Iran we do not have this phenomenon, I don't know who has told you that we have it..."

StandardDeviant's picture

It's almost a straight line, isn't it?

Thisson's picture

They found a way to turn gold into gold.  BFD.  Read the article.  It's silly.

CPL's picture

Correct, It's not just in Iran.

 

UAE is concerned about the state of affairs around the world concerning food.  Appearently nothing is showing up for delivery and it's getting tight.  So expect UAE to go into spring time soon as well.

 

http://www.thenational.ae/business/economy/uae-in-call-for-clarity-over-world-food-supply

http://twocircles.net/2012sep29/uae_charity_distributes_food_yemenis.html

http://www.khaleejtimes.com/kt-article-display-1.asp?xfile=data/nationgeneral/2012/October/nationgeneral_October34.xml&section=nationgeneral

mccoyspace's picture

Yup, that place is wholly dependent on food imports. When I was living there that though was front and center in my mind. They import all of their gasoline, too. They don't have any refineries there. They export a boatload of nat gas and oil, though.

 

another fun link from over there:

http://www.thenational.ae/news/uae-news/uae-groundwater-being-depleted-a...

falak pema's picture

Baghdad is gearing up oil production while Tehran gears down.

Eternal tweedle-dee, tweedle-dum. 

The CIA prints RIAL that helps the oil to fall in Iran. I hope it doesn't help it to block Hormuz. 

50% rial fall and you'll have 50 million iranians swimming to Bahrein. THe Hormuz will look like those autoroutes in China, all cars no traffic. 

bank guy in Brussels's picture

Smets and Wouters, bitchez! They rule!

'Explosive Inflation', just like they say!

As Tyler writes:

« ... Smets and Wouters, whoever [the f*ck] they are ... »

nmewn's picture

I had a model once, the Bounty. It took me long hours of concentration, diligence, patience, money and paint to get it all nice & purty...it was just right, so I thought. 

It keeled over to port & sank like a rock...not a cloud in the sky...I'm sure theres a lesson in there somewhere ;-)

RockyRacoon's picture

Take on ballast.  Ships are designed to haul freight/weight.  An empty ship is unstable.

nmewn's picture

lol...I think it was just never meant to sail...it was meant to be admired, adored and talked about as a work of art sitting on a shelf somewhere. 

Kinda like most models, they just can't stand the test of reality.

BidnessMan's picture

All models are wrong. But some models are useful. From my buddy Leon.

nmewn's picture

Models are useful until they break or breakdown.

I think that is the interest...the desire to understand and predict...but its really a fools errand in my opinion (in regards to economics) as no one can predict the human mind.

The worlds best & brightest minds thought and modeled that unprecedented low interest rates would make humans go into even deeper debt...the exact opposite turned out to be true.

Instead of a negative (debt) maybe they should experiment with something positive for a change ;-)

Poor Grogman's picture

The models failed to take into account what would happen when the lab rats became " aware of how the game works".

Dammit now we need a new model...

Or better tranquilizers for the lab rats...

Either way the old paradigm and all it's preists are toast.

XitSam's picture

When I was a kid and we got tired of our ship models, we would go to the 8 foot falls in the local canal.  We would put firecrackers in the ship and time it so they would blow up right as it went over the falls.

nofluer's picture

That's what I was gonna tell him. The ship is not complete without ballast. Isn't the foundation of ellis Island made up of rocks tossed overboard when ships took on freight?

Must be a land-lubber.

nmewn's picture

Try not to get caught up in reality when dealing with the absurdities around you my friend, you'll only stay in the asylum longer ;-)

RockyRacoon's picture

I used to summer on Dog Island in the Gulf.  There is a Ballast Cove on the island where ships would anchor and drop ballast before going to the mainland to take on cargo.   The ballast stones were mostly huge, near perfectly round, granite balls.  Quite a treat to find and take back for decorating the cabin.

http://slidercat.com/blog/wordpress/?p=78

nmewn's picture

Ah yes, from the old nautical days, those are good treasures to be sure. Good on ya, half the fun is searching.

I'm familiar with the area. My great-grandfather was part of a unit that guarded the salt works down the road from Carrabelle around St.Marks back in the WBTS...its a long story.

I was raised in Fla...worked at a place called CSY Yachts back in the day, I'm very familiar with ballast. I have friends who are still captains, one was a harbor master out of Tampa, the other sells yachts...all the way down to what we can afford as a boat now...lol.

I'm surprised so much attention was paid to ballast instead of the "model theory" I introduced ;-)

DanDaley's picture

A boat is a hole in the water where you throw your money in, just like government.

RockyRacoon's picture

Nature Conservancy took over most of the island -- took all the fun out of it.  Where we used to walk the beaches and pick up trash are now... well, trashed.   Nobody to pick it up.  We'd be a hindrance to "nature" don't ya know.

nmewn's picture

I hear ya...people can be pigs ;-)

Its really not that hard to take care of ones own garbage.

falak pema's picture

but before it did that, did it mutiny?  You gotta tell the whole story! 

nmewn's picture

As the "modeler"...its my own fault for not having flammable liquids on hand, to give it a proper send off...it should be noted, the life boats were glued to the sides & deck...everyone died on that model ;-)

FoxMulder's picture

I had a model once, her name was Karen. She had great legs, but she just layed there.

BidnessMan's picture

Just like the Vasa! Sweden's great ship that made it a whole mile out to sea. History does rhyme....

Landotfree's picture

"Wheelbarrows bitchez!"

I think not.  All you guys can go dash to the bank tomorrow at 9am and by 9:05am they would be closing the doors.

True inflation of the global credit system died a few years ago, what you are witnessing is the dead cat bounce, eventually the collapse will continue.

http://2.bp.blogspot.com/--RkLZLRlRi8/UGAGOUg7fNI/AAAAAAAAABs/HHgMlfUYP24/s1600/sept20latest1.gif

LMAOLORI's picture

 

 

They are already using Krugman suggestions and Marx

fonzannoon's picture

I bet these guys were debating money velocity and inflation when one of them lit their fart on fire and they saw how the sulfer ignited and whamo, it all made sense.

zorba THE GREEK's picture

We thought for sure this time would be different.

RockyRacoon's picture

Lemme see if I get the article right:   All their own evidence says that what they are doing will cause "explosive inflation".   Yet they are doing it anyway.   Did I get it about right?   Too bad Congress can't understand simple math, or a confession by a sociopath.   Ending the Fed won't happen until they blow the ship of state right out of the water.   Too late.

nmewn's picture

They're a one trick pony...just print...and it is a creation of Congress to absorb the debt it (the elected Congress & Presidents) issue.

What could possibly go wrong?

Skittles for everyone!!! ;-)

 

akak's picture

When your only tool is a printer, every problem looks like an opportunity to print.

TheFourthStooge-ing's picture

When your only tool is unconditional immunity to all laws, every problem looks like an opportunity to ass rape the world.

nmewn's picture

I always mentally picture them like a monkey with a hammer.

Osmium's picture

Strange, my mental picture of them is a monkey fucking a football.