This paper examines the implications of uncertainty about the effects of monetary policy for optimal monetary policy with an application to the current situation. Using a stylized macroeconomic model, I derive optimal policies under uncertainty for both conventional and unconventional monetary policies. According to an estimated version of this model, the U.S. economy is currently suffering from a large and persistent adverse demand shock. Optimal monetary policy absent uncertainty would quickly restore real GDP close to its potential level and allow the inflation rate to rise temporarily above the longer-run target. By contrast, the optimal policy under uncertainty is more muted in its response. As a result, output and inflation return to target levels only gradually. This analysis highlights three important insights for monetary policy under uncertainty. First, even in the presence of considerable uncertainty about the effects of monetary policy, the optimal policy nevertheless responds strongly to shocks: uncertainty does not imply inaction. Second, one cannot simply look at point forecasts and judge whether policy is optimal. Indeed, once one recognizes uncertainty, some moderation in monetary policy may well be optimal. Third, in the context of multiple policy instruments, the optimal strategy is to rely on the instrument associated with the least uncertainty and use alternative, more uncertain instruments only when the least uncertain instrument is employed to its fullest extent possible.Let me translate that for you.
This paper defends current monetary policy by applying outdated thinking to current conditions which may or may not exist on another, perhaps hypothetical planet, which we will call "Absent Uncertainty." Large and persistent demand shocks mean the models we use cannot explain the crash and stagnation. These come from another planet outside our models and concern. "Absent Uncertainty" is the only place where, presumably, inflation and GDP obey the instructions in the primitive static models of this paper.
In the real world we pretend monetary policy -- although it has not worked relative to output, employment, or inflation -- will eventually work somehow. Our important insights: One, even in the presence of considerable uncertainty about the effects of monetary policy the optimal policy nevertheless responds strongly to shocks: uncertainly does not imply inaction."
I'm sorry, I cannot translate this. It seems to make no sense. It may mean, "We do something." It seems to confuse uncertainty by economic actors over future economic conditions with uncertainty over whether the Federal Reserve knows what it is doing. Perhaps the two are related, since the Fed is holding tight to a steering wheel that is not connected to a chassis or engine or wheels, like a strange scarecrow standing in a barren field.
Likewise, we cannot translate the other two important insights, since they are likewise obscured behind excessive use of the word "uncertainty."
Calculated Risk says in response to this:
"Currently inflation is below the Fed's target (and is forecast to remain below the target), and unemployment is significantly above target (and forecast to remain above target). In general the current situation and forecasts would suggest more accommodation."
Which is in effect to ignore everything the Fed president said and shrug. The Fed is doing what it is doing, it's not making much difference, so they'll probably continue.
We don't need to get too far into the paper, thank goodness, but offer you this, quote:
"The claim that the Fed is responding insufficiently to the shocks hitting the economy rests on the assumption that policy is made with complete certainty about the effects of policy on the economy. Nothing could be further from the truth. Policymakers are unsure of the future course of the economy and uncertain about the effects of their policy actions...."
And so on. So maybe it is the policy-makers at the Fed who are the bearers of the uncertainty.
The rest of the paper offers some models, which put Greek letters to uncertainty, expectations and other amorphous psychological states, and ... sorry, enough.
Now may be a good time to repeat our analysis. Our basic forecast and explanation is that we are bouncing along the bottom with downside risks, burdened by excessive private debt and unwillingness to return to full employment via the public sector, even though we have essential tasks going undone. And the bottom is sloped downward. Official policy is aimed at the big banks and the securities markets. It has failed to produce recovery in spite of happy talk, and has actually exacerbated the inequality that is another serious burden to progress. Policy makers are stuck in a fantasy world, unable to correct their course, by reason of ignorance on one hand and political pressure from the corporate elite on the other.
Now we're going to introduce the first of four relays from Dirk Bezemer on money. Those of you on the legacy site can find the second, third and fourth of these episodes via the website, demandsideeconomics.net.
We'll be back next week with commentary on this presentation, which is good, but not complete. Certainly it compares favorably with the nonsense from the Fed, being clear, simple and accurate. Plus, it does not suggest that the sick economy is the result of "shocks" from other planets, but results from conditions within.
Oh, first, all is brought to you by Demand Side the Book. Yes, we are still selling copies. Check out DemandSideBooks.com. One year ago it was published. Don't need to change a word. Well, maybe a word. But it is still a useful introduction to demand side analysis.
Now Dirk Bezemer