The Fed is using the wrong model

Janet Yellen, chair of the U.S. Federal Reserve, from right. Scott Alvarez, general council with the U.S. Federal Reserve, Stanley Fisc
Andrew Harrer | Bloomberg | Getty Images
Janet Yellen, chair of the U.S. Federal Reserve, from right. Scott Alvarez, general council with the U.S. Federal Reserve, Stanley Fisc

The Federal Reserve's approach to policy is to spend a lot of time looking ahead and trying to make sure it is making policy for the future. May I question whether in this process the Fed is spending too little time making policy for today?

Boston Celtic coach Red Auerbach used to light a victory cigar on the sidelines when he was sure his team had won. What the Fed is doing is the equivalent of lighting the cigar at halftime with a thin lead.

Policy must look ahead but we make a reasonable case for where we are going by looking at where we are and at our current momentum. I do not get the sense that the Fed is putting enough emphasis on current conditions or to put it in a different way, that it sees the current situation only in the light of how it fits into its forecast. Analyzing the current situation for the Fed is not as crucial as it is to use it to build a forecast.

For one thing I think the Fed tends to look too much for the future equilibrium. There is all this talk about the sustainable full employment path. Right now most Fed members see us below that path for a substantial period ahead (although not below it by much).

And this is fed to us as though it is a situation that puts the economy in some jeopardy, but then Janet Yellen opines that it's OK for unemployment to be 'too low' because we need to get the inflation rate higher. Well…which is it?

But none of this has much to do with our economy or why it is behaving this way. Or why we can have an unemployment rate below its long terms path and still have a bloated mass of discouraged workers – and that is not expected to change. And how these conditions persist and yet we have skills shortages and at the same time wages that are not seeing very much pressure. And despite all this alleged job market tightness and low jobless claims we find that the quit rate is still relatively moderate.

"Policy-making has had the world upside down with the real risks in the economy largely not appreciated."

I would say that the above paragraph catalogues a considerable conundrum in the labor market that strongly suggests that analyzing it as though it is in equilibrium or headed there soon is wrong headed. We are in an economic disequilibrium and in saying that I have just explained all the anomalies above. I don't necessarily understand them but I have explained how all these things can happen at the same time.

We are still in flux toward some new equilibrium and it may take a very long time to find it. Policymakers in contrast pretend we are in equilibrium and look only at the relationships they want to value that lead them to the policy path they already have chosen as correct. And that puts things backwards.

Policy-making has had the world upside down with the real risks in the economy largely not appreciated.

Our economy is and continues to be driven by international events. To the extent that Donald Trump can scare US firms back into the US by threats against outsourcing or by being more belligerent toward out trade partners (making US investment abroad seem less safe) he begins to restore the old model of how the US economy works.

Oddly, all these things that people hate about Trump will act to make the economy work more the way it used to work. The fly in the ointment for Trump is twofold (1) the strengthening dollar that should make investment in the US less feasible and (2) how he will be able to fund his fiscal agenda (or like Reagan, will he talk budget balance and just be content to miss his 'objective?).

Whatever Trump's path I recommend looking at reality good and hard and trying to understand it much more than worrying about the economy and its future equilibrium path for the unemployment rate. As long as there is so much global slack, inflation will not gain purchase. The Phillips curve will remain out of whack and traditional models will spin out of control.

Of course rising oil prices may look like inflation for a while but that is only if OPEC can keep everyone cooperating…and in the past that was not possible and today OPEC members have less power and some key players are actually outright enemies.

I think the Fed is making policy on the wrong model. I think the warning that it may have to be more activist in 2017 may actually mean that if they overdo it, as they seem to be headed for, they may have to start cutting rates by year end. Good Fed policy-making will be in force when the Fed stops using a policy framework that has equilibrium at the center of the analysis.

We are in a period of huge disequilibria in the labor market due to the increasing role of emerging economies in global trade and to technology displacement and on the geopolitical front. That is quite a triple threat. When the Fed talks about uncertainty being higher it has only grasped the tip of the iceberg. It still does not seem to have a clue.

Commentary by Robert A. Brusca, chief economist of Fact and Opinion Economics, an economic-consulting firm in New York City. Prior to that, he was chief economist at Nikko Securities and a financial economist and Fed watcher at Irving Trust. Brusca started his career on Wall Street working at the Federal Reserve Bank of NY, where he was chief of the international financial-markets division. He was also the very first guest on CNBC.

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