Avoiding the Rattlesnakes in Monetary Policy

By Michael Ashton

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And now on to today’s rant.

Today we got the minutes from the last FOMC meeting, but that is of course old news by now. The nuance of whether the central bankers at the meeting were a little more dovish or a little more hawkish used to matter more when every utterance of every Fed official wasn’t carried live on television. By the time we get the FOMC minutes, even the nuance is outdated if Fed speakers have been active at all.

Make no mistake: I once would stop what I was doing when the minutes came out, and pored over the fine detail to pick out that nuance; but it’s no longer necessary. I am less intrigued by the wording in today’s minutes than I am by what Neel Kashkari said a few days ago.

Mr. Kashkari, who is President of the Minneapolis Fed despite his tender age of 44, declared last Friday that his colleagues’ desire to raise interest rates is attributable to a “ghost story” they are telling themselves:

 “People are worried that, if wages start to climb, if businesses have to compete with each other, you may not get gradual wage growth. You might all of a sudden get an acceleration in wages.

“I call this — and I mean this with no disrespect — I call this a ghost story, meaning, I cannot prove to you that there’s not a ghost underneath this table. I cannot prove it definitively. There may be. But there is no evidence that there is a ghost under this table. There is no evidence in any of the data that wages have this acceleration factor and are all of a sudden going to take off.”

I guess perhaps I am getting old and so am more easily irritated when young whippersnappers are blatantly disrespectful to their elders. Sure, at every age we think we have the answers. But Mr. Kashkari is so far off base here it is fair to wonder how the hell he got this job in the first place…because he clearly doesn’t understand one of the basic principles of monetary policy.

It is true what he says. There is no evidence that wages are about to take off, and I sympathize with his frustration about the Phillips-Curve cult at the Fed. I would go further and say that even if wages were to suddenly accelerate, moving higher before inflation moves higher in what is a fairly unusual occurrence, there’s very little support for the notion that this would in turn push prices higher. The data supporting “wage driven” inflation is very thin indeed. This is why the Phillips Curve tends to work fairly well on wages, but not very well on inflation. That is, low unemployment rates tend to precede increases in wages, but aren’t particularly predictive when it comes to increases in inflation.

But despite the fact that what he says is true, he is wrong about the implications for policy because he doesn’t appreciate the nonlinear effects of forecasting errors here. One of the basic rules of monetary policy is (or at least should be) this: because there are large error bars on your forecasts, try to nudge policy in the direction least likely to &*@#$^@ it up.

Kashkari is saying that there’s no reason not to keep rates low, because we haven’t seen any sign of wage inflation. But that’s not the right question. The right question is this: is it more likely that we will &*@#$^@ it up by keeping rates too low, or by moving them too high? Being wrong and being slightly too tight when you’re already incredibly accommodative is probably a small error. Being wrong and being slightly too loose when you’re already incredibly accommodative has at least the potential to be a massive error, because inflation has long tails – so making that error could have nonlinearly bad results.

One might argue that being too tight could crack the stock and bond markets. This is true, but it will always be true unless the markets crack on their own. It’s true because markets are ridiculously overvalued, so there will always be a risk of nonlinearly bad moves in asset markets. But that risk is inescapable: at some point, rates will have to be normalized, and it is likely to move the equilibrium prices for those markets lower. The Fed is trying to address that part of the risk by being so outlandishly incremental that asset markets won’t care. So far, so good.

(There is an additional irony here, and that is that raising interest rates is the action which is more likely to ignite inflation as money velocity moves up so that you might also get nonlinearly bad outcomes in inflation by raising rates. But that is not what Kashkari is saying.)

No one, it seems, is worried about the nonlinear outcomes these days. If they were, implied volatilities would be much higher, since it is through options that you can best protect your assets from nonlinear market moves. As investors, we can choose to take that risk with our own little piece of the pie. Policymakers don’t have access to option hedges on economy-wide economic variables, though. Their best strategy is to try and walk the course least likely to result in their stepping on a rattlesnake.

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