One of These Things is Not Like the Others

Among the steps the Fed has taken to increase transparency in recent years is the release of projections by the board members and regional bank presidents.  This includes the "dot plot" indicating each participant's belief about what the appropriate federal funds rate target will be at the end of this year and the next three years.

One of the dots from the latest release (I've indicated with a red arrow) shows a preference for a negative fed funds rate this year and next, and a much lower rate than everyone else expects at the end of 2017.

People on twitter seem to think its most likely Minneapolis Fed President Kocherlakota's dot.  It called to mind this, from the deep recesses of childhood memory:
(That's from Sesame Street). 

Of more serious interest, the projections also included a reduction in the median "longer run" federal funds target, to 3.5%, from 3.8% at the last release in June, and also a lower estimate of the "longer run" unemployment rate, which might be taken as a proxy for a NAIRU estimate (see Krugman).

Rodrik on Economic Models

There is an an excellent piece by Dani Rodrik on economic methodology at Project Syndicate:

Economics is not the kind of science in which there could ever be one true model that works best in all contexts. The point is not “to reach a consensus about which model is right,” as Romer puts it, but to figure out which model applies best in a given setting. And doing that will always remain a craft, not a science, especially when the choice has to be made in real time.

The social world differs from the physical world because it is man-made and hence almost infinitely malleable. So, unlike the natural sciences, economics advances scientifically not by replacing old models with better ones, but by expanding its library of models, with each shedding light on a different social contingency.

Or, as Keynes put it, "Economics is the science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world." 

Rodrik goes on to discuss Borges' story "On Exactitude in Science" - a parable about cartographers who make a map on the same scale as the world it was meant to represent.  This story, which was our reading for Econ 110 yesterday, illustrates the point that "more realistic" isn't necessarily better.

A Note on "Credibility"

Fed watchers are speculating that the FOMC meeting later this month might be the occasion to raise the federal funds rate target off the "zero lower bound," where it has been since December 2008.  In a column arguing against such a move, Larry Summers writes:

From the Depression to the Vietnam War to the Iraq war to the euro crisis, we surely should learn that policymakers who elevate credibility over responding to clear realities make grave errors. The best way the Fed can maintain and enhance its credibility is to support a fully employed American economy achieving its inflation target with stable financial conditions. The greatest damage it could do to its credibility would be to embrace central-banking shibboleth disconnected from current economic reality.

At the Fiscal Times, Mark Thoma writes:

The inflation problems of the 1970s, the loss of Fed credibility that came with it, and the need to impose the Volcker recession in the early 1980s to bring inflation down to tolerable levels made an indelible impression on policymakers who lived through that time period. The Fed’s trigger-happy response to any suggestion of an inflation problem is directly related to the desire to never let such an inflation outburst happen again.

But it has been more than four decades since the beginning of the inflation problems of the 1970s, and the economic environment in which monetary policy operates has changed considerably since that time. Those changes support patience, particularly in response to increases in wages, wages that have been stagnant since the 1970s even as labor productivity has been increasing.

The "credibility" argument in monetary policy is based on the idea that the central bank will be tempted to use inflation to "overheat" the economy and bring unemployment down below its "natural" (or equilibrium) levels for political reasons - e.g., to help the incumbent party in an election year.  Any gains would be, at best, short-lived, as people would incorporate a higher level of inflation into their expectations and set wages and prices accordingly.  Based on this logic - which seems helpful for interpreting how we got into the "stagflation" of the 1970s - economists look for policies and institutional structures to correct this perceived inflationary bias.

In the past several years, this logic seems turned on its head.  If anything, the biases of our monetary policymakers appear to be in the other direction.  Inflation continues to be subdued, as this plot of one of the Fed's preferred measures, the "core" deflator for personal consumption expenditures, shows:

The red line is drawn at 2%.  Measures of expected inflation are also below 2%.  David Beckworth recently argued that the Fed is acting as if 2% is a ceiling, not a target - he suggests the Fed's behavior is consistent with it aiming to keep inflation between 1% and 2%.

But the the Fed declared in 2012: "The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate." If the goal is to "anchor" expectations at 2%, the Fed is at risk of failing, but the greater threat to its credibility seems to be too little inflation, not too much.

China and the Solow Model

Last month, just before China let its currency deprecate and its stock market crashed, the San Francisco Fed published a nice Economic Letter by Zheng Liu, "Is China's Growth Miracle Over?"

China's rapid, but decelerating, growth is broadly consistent with the implications of the classic Solow growth model we teach our intermediate macroeconomics students.  This model predicts that low-income countries should grow quickly, but growth will slow down as they approach the leading countries, whose per-capita growth is constrained by the rate of technological progress. That is, there should be "convergence" in per capita GDP.

As this chart from the letter shows, China is following a similar path to Korea and Japan.

The basic intuition from the model comes from the idea of diminishing marginal product of capital - i.e., where capital (machinery and equipment) is scarce, the increase in output from adding an additional unit is greater than where it is already abundant.  This diagram of output per capita (y) as a function of capital per capita (k) illustrates,

where the slope is the marginal product of capital (MPk).

The idea can be extended to include "human capital" (i.e., knowledge and skills), as Mankiw, Romer and Weil did in a 1992 paper.

While the Solow model gets the broad contours of the growth experiences of Korea, Japan and (it seems so far) China correct (and does pretty well for the US as well), it does miss a couple of big things:

(1) A diminishing marginal product of capital implies that the financial rewards to investing in a low income country should be vastly higher than in high-income countries.  In a world where people can invest across borders, this implies a huge incentives for financial flows from high-income to low-income countries, but we do not observe such large net flows.  This was the puzzle Robert Lucas noted in a 1990 paper.

(2) While the experiences of some low-income countries is consistent with the convergence hypothesis; in many cases, low-income countries have fallen further behind (or, as Lant Pritchett wrote, "Divergence, Big Time.").  From the standpoint of the Solow model, growth "miracles" like those of Korea are to be expected, and the real puzzle is the fact the failure of so many countries to converge.

As Moses Abramovitz pointed out in 1986, it is usually a subset of the low-income countries that are growing fastest.  This would suggest there are forces for convergence, but something is preventing them from applying everywhere.  Current thinking is that the answer lies in "institutions" - the set of legal rights, culture, and governance which shape the economic environment and incentives for people to take actions within it, including to accumulate capital.

This is where assuming that China will continue to follow in the convergence footsteps of Korea and Japan may be questionable.  While China's institutions have gotten it this far, there are reasons to doubt whether they are appropriate for achieving levels of GDP per capita comparable to Korea, Japan and Europe, as this column by Brad DeLong and this by Eduardo Porter discuss.  That said, the institutions in the US during its late 19th century industrialization were hardly what an economist would recommend (in particular, corruption was rampant), and yet it somehow managed to take over leadership in per capita GDP from Britain.