Mr. Bernanke: Don’t Forget About the Circularity Problem

This is from a recent WSJ article:

Whether the Fed makes any move next week depends in large part on economic data, particularly the government snapshot of the jobs market due Friday. Since Fed officials last met in June, data on consumer confidence and spending have softened and job data haven’t improved. But overall financial conditions have improved somewhat, with a rebounding stock market.

Officials in the Fed’s anti-inflation camp aren’t convinced the economy is slowing significantly and are wary of taking new actions. Others are eager to consider new steps to address recent signs of a slowdown and persistent high unemployment.

Fed officials aren’t yet prepared to take the larger step of resuming large-scale purchases of mortgage-backed securities or U.S. Treasurys. But they are holding open that option if the economy deteriorates. Private forecasters generally expect real GDP to grow by an annual rate of about 2¾% in the second half of 2010. If the picture deteriorates and they forecast growth falling below 2%, the Fed would be more likely to act.

It is true that the stock market has recently rallied, and I agree that this does slightly reduce the odds of a double dip.  But it is also important to think about why stocks rallied in July.  Some market observers attributed the rally to rumors that the Fed would eliminate interest on reserves, or do some more QE.  This article indicates that neither step is likely, in which case stocks could easily fall if next week’s meeting produces a disappointing outcome.

I doubt that rumors about possible Fed easing were the primary factor driving stocks higher last month, but nevertheless it is important to keep in mind the “circularity problem,” which occurs when markets are watching the Fed and the Fed is watching the markets.  If markets rallied because they expected the Fed to do something, and the Fed decides that nothing needs to be done because . . . well because the markets rallied, then we are not going to get anywhere.

BTW, the first time I saw the circularity problem discussed was in a couple papers published in 1997.  One was by Larry White and Roger Garrison, and the other was by Michael Woodford and some guy named Ben Bernanke.

I’m still trying to figure out why the WSJ doesn’t expect the Fed to do anything.  We have had about 4% NGDP growth over the past 4 quarters, which basically means we are just treading water, not recovering.  RGDP growth is expected to be about 2.75% going forward, roughly the trend rate of growth for the economy.  Assuming inflation continues to run around 1% to 1.5%, then NGDP growth will continue at 4%.  In other words:

1. The economy has not really been recovering over the past year.
2. The economy is not even expected to begin recovering in the second half of the year
3. We are in the worst recession since the 1930s
4. Fiscal stimulus will be reduced over the next year
5. Ergo, no need for more monetary stimulus.

If my students asked me what the Fed was thinking, I would have a hard time even answering the question.  I suppose I could mumble something about inflation fears.  But then there is this from the same article:

The Fed is in a difficult spot. As Mr. Bernanke noted, inflation, now about 1%, is likely to run below the central bank’s unofficial target of 1.5% to 2% for the next couple of years. That is stoking worries of deflation, a debilitating fall in prices across the economy. Unemployment is expected to remain high even longer.

I would have thought that put the Fed in an incredibly easy spot.  Really bad recession, no sign of recovery, no additional fiscal stimulus, inflation falling well below target, worries of deflation.  Hmmm. . . . these decisions are just so difficult.