The Circularity Problem is Making Me Dizzy

Here is a recent story from Yahoo.com:

NEW YORK (Reuters) – Stocks rose on Tuesday after opening lower on weak economic data, with investors saying the data bolsters expectations the Fed will pump more money into the economy, which would support equities.

And what sort of economic data was weak?

September data showed U.S. consumer confidence fell to its lowest level since February, underscoring lingering worries about the strength of the economic recovery, while home prices dipped in July.

Let’s suppose consumers react with a lag to economic data, or suppose the survey was done early in the month.  In that case the survey might have reflected the very weak economic data coming out in August (revised GDP at 1.6%, etc) and also a weak stock market, which was partly a response to the weak data.

So let me get this straight:

1. The markets were weak in August, causing a low consumer confidence number in September
2. This leads investors to expect more easing by the Fed
3. This leads to a stronger stock market
4. This will lead to a better consumer confidence number in October
5. Which will lead investors to fear the Fed won’t ease
6. Which will cause stock prices to fall in October
7. Which will lead to a weaker consumer confidence number in November.
8. And so on

Are you getting dizzy yet?  This is the so-called “circularity problem,” which occurs when the Fed tries to target market expectations.  It was discussed in 1997 in a pair of JMCB papers by Garrison and White, and also Bernanke and Woodford.

The Fed needs to be careful here.  It’s easy to say the Fed doesn’t respond to the stock market; but let’s face it, they do.  They cut rates after the 1987 crash, even though there was no sign of recession or deflation, and they announced a bond purchase program in March 2009, right after a sickening plunge in equity prices.  Make all the jokes about the stock market you want, people do see it as an important indicator of which way the economy is headed.  Even if only subconsciously.

So if the Fed were to meet in November and decide not to do QE because the market was looking up, and if the market was looking up because they expected QE in response to weak economic data, then the Fed could end up with a nasty surprise.  Something like what occurred in December 2007 and January 2008, or again in September 2008 and October 2008.  Using Wall Street lingo, they could “fall behind the curve.”

Of course none of this would be a problem if the Fed used the sort of futures targeting idea I proposed back in 1987 (or similar ideas by people like Dowd, Woolsey, Jackson, etc.)  But that’s not going to happen, so they’re going to need to be very careful in evaluating market signals.  I almost broke out laughing when I read the first paragraph of that Yahoo story–it’s a near perfect example of the circularity problem.

I worry that the Fed does not fully appreciate the circularity problem.  From the WSJ:

Under the alternative approach gaining favor inside the Fed, it would announce purchases of a much smaller amount for some brief period and leave open the question of whether it would do more, a decision that would turn on how the economy is doing. This would give officials more flexibility in the face of an uncertain recovery.

.  .  .

Markets anticipate the Fed will pull the trigger, barring some surprise turn in the economy. Economists at Goldman Sachs Group Inc. estimate the Fed will end up purchasing at least another $1 trillion in securities, and estimate that would push long-term interest rates down by a further 0.25 percentage point.

A leading public proponent of a baby-step approach is James Bullard, a 20-year Fed veteran who has been president of the St. Louis Federal Reserve Bank since 2008. He says he has made progress convincing his other colleagues to seriously consider that path.

“The shock and awe approach is rarely the optimal way to conduct monetary policy,” he says. “I really do not think it is the right way to go except in really exceptional circumstances.”

These are exceptional circumstances; we’re in a Great Recession.  Aggregate demand is expected to remain far too low to allow for a robust recovery.  The only way this dynamic can be changed is if the Fed does much more than the markets currently expect.  That means shock and awe.  It’s a pity it won’t happen.

PS. I notice that Yahoo.com changed the wording of the article I linked to.

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