The Fed dog is not being wagged by the freshwater or saltwater academic tails

This post replies to a Bloomberg View piece by Noah Smith, which I would caricature as describing the Fed’s economic analysis staff as a dog being wagged alternately by laissez faire freshwater, RBC academics and then activist, sticky-price New Keynesian thinkers.

The picture he paints is worrying, because, if, like me, you are convinced that the Fed should be actively using its instruments to smooth the business and inflation cycle, you might worry from his description of things that soon the freshwater lot will win out and the Fed will, well, give up and go home.

But I don’t see the Fed economics community like that. I’m not and never have been a Fed insider, so this reply comes with that health warning, but…

For starters I see that the activist school of thought holds sway, and has always held sway over the last 30 years, and there’s no danger of the flexible price academics taking over.  I also don’t see the Fed as a passive participant in the battle for ideas, but as an active and, along some dimensions, pioneering and decisive force.

I’d cite several bits of Fed intellectual activism.

a) the embracing of the Cowles Commission program for macro and policy modelling.  In academia, these models died off completely, living on only as fond regrets in the occasional academic blogger. But in central banks, where they were ‘perfected’, they lived on.  Even now the Board of Governors has FRB-US, which is, huge, only partially microfounded, embraces departures from rational expectations, and is used for forecasting.

b) the working out of the early pieces of wisdom about good and bad policy rules, on these pre-NK linear, rational expectations models. Taylor is credited with crystallising the ‘Taylor Rule’ (hence the name). But actually many in central bank circles credit the development of rules like this – both their good performance in models, and their similarity to actual central bank rates – to the published and unpublished work of people like Bryant, Henderson, Mckibben and others, all at the Board of Governors at the time.

c) the embellishment of, and the implications for optimal policy of the new NK models. A line of work through Blanchard-Kiyotaki, then Rotemberg-Woodford and McCallum-Nelson developed the first microfounded NK models for policy analysis. But Fed economists took these on stages further, and the major journals have many papers by Fed economists at the time, like Erceg, Henderson, Levin, Williams, Laubach, Edge, Kiley.    (Actually, on reflection, you could even interpret Woodford’s early papers on inflation stabilisation and welfare as a response to the conviction, then unfounded, that the Fed should be stabilising weighted sums of inflation and output gap deviations.  They were missions to formalise what the Fed already felt instinctively was the right thing to do.)

d) policy analysis with non-rational expectations: this was a literature begun by those outside the Fed – Bray, Sargent, Evans and Honkapohja. But several papers by Orphanides and Williams discussing the implications of non-rational expectations and less than perfect information brought this work to centre stage. Retaining the capacity to simulate the main policy model under alternatives to rational expectations could itself be seen as intellectual activism. Many central banks don’t.

e) Quantitative Easing. This was pursued vigorously, despite most knowing that the prevailing NK wisdom was that it would not work, and only later did evidence accumulate that it might work, in the sense of having material effects on yields. I count this as intellectual activism (leading clearly to policy activism).  As well as doing it, the Fed have naturally been at the frontier of trying to figure out whether it worked or not.  Other central banks have too.  But the Fed, which is distinctive in allowing staff to publish results that might be off-message in policy terms (contrast the UK where research outputs were always actively filtered) has been able to speak with some credibility.  The same intellectual actvism is evidence by the other post-crisis interventions too – like the TARP, TALF schemes, for example.  Or, of course, the decisions to bail out or not.

f) Monetary policy and robustness.  I credit the Fed with decisive contributions here too.  Particularly with work on the ‘fault’ tolerance of Taylor-like rules, (how wrong can you go if you get the model wrong) relative to pursuing what you think might be optimal policy, but might turn out not to be.  This work is surveyed in the Handbook of Monetary Economics chapter by Taylor and Williams [FRBSF President], and features original work by other Fed staff.

Debating Noah on Twitter, he countered by wondering about the vocal RBC-ers in the employ of the Federal Reserve System. If they have no effect, how come they are there? Isn’t their presence evidence of the battle of ideas in the Fed still going on? Possibly. But a few responses.

1)To an outsider at least, it seems to me that the policy debate is shaped more by those in the Board of Governors than the regional Feds. With no systematic evidence whatsoever, I assert that the RBC-ers are disproportionately located in the regions.

2)The business model behind hiring researchers encourages a policy of letting many flowers, including modern RBC, bloom. To get the benefit of the cleverest economists and their insights into policy, you have to give them a certain amount of their time to do what they want.

3)Many sticky price central bank activists have at the core of their preferred model a beating RBC heart. So RBCers have a lot to say to them that’s useful. For example, about real frictions that might exist, and the possibility of real tools used recently by the central bank, and monetary policy, to alleviate them.  Such people often view the job of monetary policy as being to try to make the economy look as much like the RBC one as possible had the frictions not got in the way.  Seen like this, it’s obvious why you need RBC people to tell you how to do monetary policy.  Also, RBCers in the Fed system, many pioneers in modern macro, are often those contributing to the debates about methodology that central banks have to care about: how to build models and solve them, and how to test them.

So, with interest rates pressed against the zero bound, and quantitative easing purchases having swelled the Fed balance sheet, both expressing the prevailing view that the Fed should strain as hard as it can to achieve its dual mandate (the employment goal of which would make little sense to the Freshwater lot), I don’t expect a retreat any time soon.  That is, not until the data warrant it and the activist controllers at the Fed see their job as done.