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

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by Tyler Durden
Wednesday, Oct 03, 2012 - 18:04

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 effects of forward guidance
  • While the literature has provided strong theoretical justications for the use of such forward guidance (e.g., Eggertsson and Woodford (2003)), the evidence on the quantitative effects 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 identication 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 eects 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 effect 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 effects 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 finding 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: