Learning to See Brown Shoots Instead of Green Ones

June 21st, 2012 at 6:56 pm

Lots of focus on the Federal Reserve’s announcement yesterday to twist again (here’s Greg Ip’s take at The Economist).  Twist 2 is another dose of so-called unconventional monetary stimulus.  In this case, they swap out some of their holdings of short-term debt for longer-term debt, intended to lower interest rates at the long end of the yield curve.

I’ll say a bit more about the impact of this in a later post—as Fed chair Ben Bernanke himself intimated, I’m not sure lower long term interest rates help much right now.  It’s neither the cost of capital  nor the amount of cash reserves investors have on hand that’s holding back the recovery.  It’s lack of consumer demand.

Here, I’d like to focus on yet another downgrade in the Fed’s forecast.  The figure below shows their estimate for 2012 real GDP growth starting with their Jan 2010 forecast up through the one released yesterday (I’ve taken the average of their low/high estimates).

Source: Federal Reserve

As you see, they’ve steadily dropped such that their guess for 2012 is now 2% of GDP lower than it was a few years ago.

OK…what’s the point?  It’s not that they’re lousy forecasters.  This is a common pattern—for years now, economic forecasters have continuously predicted recovery, gotten a spate of bad news, and pushed their recovery prediction out a few quarters.

The problem is structural, i.e., it’s in the models, which fail to adequately account for the loss of wealth that’s beset most households, the subsequent deleveraging, and the impact of these dynamics on the macroeconomy (see here, e.g.).

As I’ve stressed elsewhere, the loss of housing wealth is particularly problematic in this regard.  First, as Case et al show here, the impact on consumer spending from the loss of housing wealth is particularly large (relative to standard wealth effect estimates, their estimate from lost housing wealth is 3-4 times greater).

Second, when an equity bubble bursts, like the dot.com example in the late 1990s, it mops up more quickly as “mark-to-market” takes your pet rock shares to zero pretty fast.  But in a debt-financed housing bubble, “extend-and-pretend” kicks in, as banks have strong incentives to avoid admitting that non-performing loans are burning a hole in their balance sheets.

These observations are known to Fed forecasters, I’m sure, as suggested by the downward adjustments to their estimates.  After enough of your green shoots turn brown, you hopefully learn to recalibrate.

So, now that we’re improving the models, how about improving the economy?

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11 comments in reply to "Learning to See Brown Shoots Instead of Green Ones"

  1. Tyler says:

    The idea that the Fed can stimulate the economy is another big lie coming from the mainstream media: http://rodgermmitchell.wordpress.com/2012/06/19/traders-buy-2-myths-fed-and-austerity-stimulate-economy-proof-money-and-brains-dont-always-go-together/

    Can the Fed cut taxes? No. Can the Fed increase spending? No. Therefore, can the Fed increase employment? No.

    • Peter K says:

      Tyler you’re ignoring a lot of history where central banks caused recessions and recoveries. Like when FDR went off the gold standard. Or Volcker hiked unemployment.

      Great chart. The trend is not our friend. Please pass the brown shoots.

      I wonder if the Fed models in the fiscal austerity coming from the state and local level.

      How bad would things be if not for easing gas prices and downward nominal wage rigidity?

      • Tyler Healey says:

        Peter K,

        I was writing in the present tense. We’re already off the gold standard, so that option does not exist. Furthermore, the high unemployment of the early 80s was caused by OPEC’s oil-price hikes.

    • Matt D says:

      Well, for one thing, they could stop restraining the economy. They’ve made it clear they don’t care about unemployment if inflation goes above 2%.

      • Tyler Healey says:

        Matt D,

        Are you suggesting that the Fed could cause inflation to rise in our current economy, where demand is so depressed that 13 million Americans are out of work?

  2. Chris G says:

    >”It’s not that [people at the Fed are] lousy forecasters. This is a common pattern—for years now, economic forecasters have continuously predicted recovery, gotten a spate of bad news, and pushed their recovery prediction out a few quarters.”

    At the risk of sounding glib, the evidence suggests that they are lousy forecasters. If you don’t accurately predict future conditions then you are, by definition, a lousy forecaster. If they repeatedly push their recovery prediction out a few quarters because they’re original forecast was wrong… THEY’VE GOT A BAD MODEL!!! At the very least you’d hope they’d recognize the shortcomings and issue disclaimers and/or increase the size of the error bars. Just knowing how to turn the crank on a model doesn’t make you a good forecaster! If that’s all one knows how to do then one is, at best, a good technician.

    • Jared Bernstein says:

      Right. I think my point here is that they’re not uniquely bad at this–most everyone in the forecasting biz has been making similar mistakes.

  3. Ryan says:

    Can somebody explain why the fed buying long term bonds lowers the long term interest rate? Wouldn’t selling additional short term bonds while buying long term bonds move the interest rate on long term bonds up and the interest rate on short term bonds down?

    • Jared Bernstein says:

      Bond prices and their yields move in opposite directions. If the Fed buys more bonds of a certain maturity, it tends to push up their price a bit and lower their yields.

  4. Frank Lysy says:

    Jared is right about the disappointing pace of the recovery. And he is correct that the bursting of the housing bubble, with the consequent loss of paper housing wealth, has reduced consumer demand. But were households to consume more at this point, with household incomes as they are, personal savings rates would fall. Yet the personal savings rate was only 4% in the first quarter of 2012. While this is an increase from the 2% personal savings rate seen during the bubble years in the middle of the past decade, both of these rates are low, and are not a basis for sustained growth.

    The fundamental cause of the weak recovery is not excessively high personal savings rates (as Jared is implicitly saying), but rather that government spending has been inadequate and has acted as a drag on the economy. As he himself has noted before, there has not been an explosion of government spending during the Obama term, despite the assertions of Republicans. As noted in a blog posting at http://aneconomicsense.com/2012/03/03/recovering-from-the-recession-fiscal-drag-can-explain-the-slow-recovery/, government spending growth has been limited during the Obama term, in contrast to the growth of government spending seen in the recovery from previous US downturns. That blog post estimates that if government spending had been allowed to grow in the current downturn as much as it had under Reagan following the 1981 downturn, we would now be at full employment.