Inevitable "errors"

One of the problems with the English language is that words such as "mistake" and "error" connote shortfalls from a feasible ideal when in fact, in some important cases, errors are inevitable and unavoidable.

I'm prompted to say this by Yian Mui's piece which points out that "the Fed has continually underestimated how much support the economy needs" in the last seven years. A similar thing is true in the UK. For example, the Bank of England forecast two years ago that inflation would now be around 2% but in fact even the core rate is just 1%.

These "errors", though, are not corrigible. Macroeconomic forecasts are inevitably subject to a margin of "error". And this margin is especially big just when we need forecasts most, to warn us of recession; as Prakash Loungani pointed out in 2000 economists have a perfect record of failing to foresee recessions, a fact corroborated by subsequent experience. These "errors" aren't due merely or even mainly to economists' incompetence but to the fact that the economy is a complex process whose outcomes depend upon inherently unpredictable network effects. As GLS Shackle said years ago, accurate forecasting is pretty much impossible*.

This in turn means that monetary policy "errors" are common and inevitable, simply because policy affects the real economy and inflation with a lag - remember the title of Tony Yates' blog - and so the right policy now requires foresight as to future economic conditions.

In the absence of such foresight, though, policy will often be "wrong". The recession of 2009 implies that policy was too tight in 2007-08 and the fact that inflation now is well below its (symmetric, remember) target implies that policy was too tight some months ago.

These "errors", though, are not eliminable bugs but features; forecast-based policies will often be wrong.

It's for this reason that, like Tony, I am lukewarm about money GDP targets: I can't get excited about whether it's better for the Bank to miss a money GDP target than an inflation target.

Instead, in thinking about monetary policy we must give great weight to the inevitability that policy will be wrong.

This has, of course, long been a feature of the literature. Back in the 1960s, William Brainard said (pdf) that it meant that central banks should (pdf) be slow to change rates - a principle which the Fed followed for years. And textbooks say that central banks should (pdf) minimize a loss function. The precise form of this function is, though, debatable. Simon says that at low inflation, the Bank should put more weight upon output losses than inflation overshoots, but JP Koning says this isn't necessarily true if interest rates can become negative.

All of this leads me to why Labour would be foolish to abandon central bank independence (pdf)**.

One reason why is that the gilt market could interpret even the honest policy errors of a rate-setting Chancellor as being in fact politically motivated, by a desire to stoke up booms. This would raise inflation expectations and hence nominal interest rates. Independence removes this interpretation and hence allows rates to be lower: this, or something like it, was the argument upon which independence was founded in the 90s.

There is, though, another reason for independence. If Chancellors set interest rates the media, in its imbecile failure to see that "errors" are inevitable, would blame them for even honest and unavoidable "mistakes": imagine how much worse the criticism would be of Gordon Brown if he had been responsible for interest rates in the mid-00s. The political case for central bank independence is to ensure that somebody else is the fall guy for inevitable policy "errors".

* The fact that one or two people foresaw the crisis of 2008 doesn't refute my point. Successful monetary policy requires not that forecasts be right sometimes, but that they be right all the time. AFAIK, nobody has achieved this, even roughly.   

** I mean operational independence: Richard is right that its independence is circumscribed.

Comments

[Metatone]

The problem is that CBI produces a predictable and repeated issue over the last 10 years. The undershoot isn't about "inevitable error" - it's about cultural pressures on the MPC, who want to curry favour with their peers working in finance, by favouring "strong policies."

CBI leads to policy dictated by the preferences of the financial industry. Maybe not an issue in New Zealand or Canada - but in the UK - a huge problem for our attempts to rebalance our economy.

[Felipe]

There is an error underlying this post, and it is shown by this quote:

I can't get excited about whether it's better for the Bank to miss a money GDP target than an inflation target.

I won't comment on why NGDP is better than inflation as a target (it is not relevant for the error underlying this post). But one point of NGDP targeting is that it is *level* targeting. This means that the inevitable errors you mention are symmetric around the target. I undershoot this year, I make it up next.

The errors central banks are making around the world, just as they were in the 70s, are systematic, not random. That fact suggests quite strongly that they are, in fact, avoidable. If an error is consistent, then you can compensate for it.

[Peter K.]

The point is that in the U.S. context the Federal Reserve has always been wrong *in the same direction*, always overshooting in its predictions of inflation and growth.

That leads one to believe there is something systemic going on.

The politicians and media don't seem to care that the Fed has consistently undershot its inflation target. An NGDP level target would be more of flashing red signal and siren I would think. The Fed is wasting billions in lost output every year by continually undershooting its NGDP level target? That might motivate Congress and the press. Or maybe not.

[Metatone]

I line up with the other two commentators that it looks like a systematic fault. However, I don't believe that NGDP level targeting can fix that - it's a cultural issue and that's why I suspect that in the long term politicians will have to take back responsibility for the interest rates, etc.

Of course, half the time the politicians (e.g. of the Right) are of the same culture as the MPC of whoever. But at least some others have some different views.

[Deviation From The Mean]

"One reason why is that the gilt market"

Who is this gilt market when he is at home and why does he get to determine our future?

Also, I have always believed you learn more from your mistakes than you successes, but in 'spontaneous disorder' system such as the market system I am not sure this is the case. The planet could be going to hell and Mr Gilt Market wouldn't see it!

Thinking about it, I think markets are the problem.

[Bob]

"One reason why is that the gilt market could interpret even the honest policy errors of a rate-setting Chancellor as being in fact politically motivated, by a desire to stoke up booms. This would raise inflation expectations and hence nominal interest rates. Independence removes this interpretation and hence allows rates to be lower: this, or something like it, was the argument upon which independence was founded in the 90s."
Really desperate stuff. Rates will be permanently set at zero under MMT.
And what is wrong with a "boom" anyway.
And if the Chancellor wants to have a "boom" how will the "independent" central bank stop him?

[Bob]

"There is, though, another reason for independence. If Chancellors set interest rates the media, in its imbecile failure to see that "errors" are inevitable, would blame them for even honest and unavoidable "mistakes": imagine how much worse the criticism would be of Gordon Brown if he had been responsible for interest rates in the mid-00s. The political case for central bank independence is to ensure that somebody else is the fall guy for inevitable policy "errors"."
Correct. The "independence" is a total sham and is used to deflect criticism, which is why it is bad for democracy.

[Bob]

"I mean operational independence: Richard is right that its independence is circumscribed."
What? If you have any sense you would merge it into the DMO. Are you sure you understand how the system works?
Read:
http://neweconomicperspectives.org/2015/09/corbynomics-101-its-the-deficit-stupid.html

[Neil Wilson]

Nominal interest rates can be set where the state wants them set by the simple act of have an National Investment Bank set loan rates at the required value.

Commercial banks then either compete, or go bust. Either is fine.

This silly game of shuffling interest rates around in order to indirectly get somebody to borrow money for something is stupid. It makes no sense at all.

Cut out the middleman and have more direct control.

[Luis Enrique]

Yes we all know that when asked to predict the roll of 2 dice that 7 is the correct answer and subsequently rolling 10 does not reveal an error, yet time again we see people being critised for getting things "wrong" when actually they made a reasonable call in an uncertain environment. but we find it very hard in practice to distinguish an ex ante good call that turns out different from an ex ante bad call, because often we have no idea what the ex ante good call is, and all we have to go on is the ex post result. In that environment the best we can do is evaluate according to outcome because at least then we will learn something on average .

[Bob]

Luis, that makes no sense. What are you talking about?

[Bob]

"yet time again we see people being critised for getting things "wrong" when actually they made a reasonable call in an uncertain environment. but we find it very hard in practice to distinguish an ex ante good call that turns out different from an ex ante bad call, because often we have no idea what the ex ante good call is, and all we have to go on is the ex post result. In that environment the best we can do is evaluate according to outcome because at least then we will learn something on average ."
It's very simple actually.
If there is a recession or low growth and rising unemployment and underemployment you cut taxes and raise spending.
If there is strong growth and things are close to capacity you raise taxes and cut spending.
And you have very strong auto stabilisers to do this automatically, including a Job Guarantee so that when firms hire they get workers who get out of bed, do not have weakened mental and physical health due to unnecessary unemployment, for a smoother transition.
Notice I didn't mention interest rates.

[Bob]

"Macroeconomic forecasts are inevitably subject to a margin of "error". And this margin is especially big just when we need forecasts most, to warn us of recession; as Prakash Loungani pointed out in 2000 economists have a perfect record of failing to foresee recessions, a fact corroborated by subsequent experience. These "errors" aren't due merely or even mainly to economists' incompetence but to the fact that the economy is a complex process whose outcomes depend upon inherently unpredictable network effects. As GLS Shackle said years ago, accurate forecasting is pretty much impossible*.

This in turn means that monetary policy "errors" are common and inevitable, simply because policy affects the real economy and inflation with a lag - remember the title of Tony Yates' blog - and so the right policy now requires foresight as to future economic conditions."
Dillow - "we can't do anything!"
Yes we can. Recessions can and should be avoided.
So basically monetary policy is completely useless, yes?
You don't worry about "future economic conditions." You worry about now.
Imagine if you said these things about fiscal policy? Would you say the Eurozone austerity is an "common and inevitable" error.

[Bob]

"These "errors" aren't due merely or even mainly to economists' incompetence"
Yes they are. Stop deflecting blame from your friends in the ivory towers. The errors are completely due to economists' incompetence.
You just don't get it. Because you are a libertarian and don't want to get it.
You might as well argue that central banks should be allowed to change which colour tie they wear and if those evil wicked Politicians (oh no, the State has power!) choose it and take away their independence then they will be.. held accountable. Because we said tie colour matters. OMG! We must protect Central Bank Independence!
Crazy train of thought.
Your libertarianism means you don't understand authority. For example:
"Chancellor as being in fact politically motivated,"
The rest of this is the "efficient market hypothesis" repackaged which is complete BS.
So how come Mike Norman is making a huge amount of money in the FOREX market, where no theoretical theory has ever held up to evidence.
Why is Warren Mosler so rich? Magic?
The whole economics profession is disgusting.
Sorry for being blunt (you may consider it rude) and thanks for the open blog, but I disagree with this very strongly.

[Metatone]

Read Duncan Weldon's tweet stream for a great example of how the prevailing "serious" consensus works against reaching inflation targets. He can't help himself - one quarter of good results and it's "hike now" - and he didn't used to be that way - but in the new job, surrounded by City economists... that's the mindset that develops.

[Bob]

"This in turn means that monetary policy "errors" are common and inevitable, simply because policy affects the real economy and inflation with a lag - remember the title of Tony Yates' blog - and so the right policy now requires foresight as to future economic conditions"
I won't let you fall into The Bubble!
Please read this blog - the costs of unemployment.
http://bilbo.economicoutlook.net/blog/?p=17740
The human and economic costs are massive.
In addition low output utilisation leads to diseconomies of scale that raises inflation in the "future economic conditions."
We can't send goods forward in time to our children. Break the bubble!

[Bob]

Pretty bad forecast this eh Chris ;)
http://www.lrb.co.uk/v14/n19/wynne-godley/maastricht-and-all-that
Look up "Mike Norman Economics" an economic forecasting site.
I have seen with my own eyes they forecast and it happens.

[chris]

Sorry Bob, we're at cross-purposes here.
You say: "If there is a recession or low growth and rising unemployment and underemployment you cut taxes and raise spending."
I agree! But this leaves the question: can discretionary policy - fiscal or monetary be used IN ADVANCE to prevent recessions? I don't think it can - and you've given me no evidence that SHORT-TERM forecasts are good enough to allow us to do so.
Regular readers will know that I do NOT say this to say that unemployment should be tolerated.
http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2012/03/remember-unemployment.html
Instead, it creates a case for much stronger automatic stabilizers - a Job Guarantee as you say and a high basic income.
http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2015/07/in-defence-of-welfare.html
Also, one implication of what I'm saying is that financial market pundits are mostly charlatans.
My point here is intended to be a radical one. I thought that was obvious.

[chris]

@ Filipe - I take your point. But the distinction here isn't NGDP or inflation targets, but rather levels vs growth targets. Levels target for either CPI or NGDP would mean that policy errors are reversed: excessively tight policy that cause low CPI or NGDP growth would lead to looser policy to get CPI/NGDP back to their levels target.
It seems to me that the case for levels targeting rests upon the point I'm making - that errors are inevitable and so must be corrected.

[Bob]

"Also, one implication of what I'm saying is that financial market pundits are mostly charlatans. "
Well I can agree with you there!
I think the number one problem with recessions is the political will. In early 2008 in the US they introduced stimulus but just stopped? Why?
And you would have very strong auto stabilisers.

[Richard]

A biased estimator and an unbiased estimator will both inevitably make errors, but the unbiased estimator will make errors that will largely cancel one another out. A biased estimator will do no such thing.

Fed estimates over the last seven years have consistently been overly-optimistic. The Fed has had a biased estimator over the last seven years, and the cumulative effect of those errors calls for correction.

[Blissex]

«the unbiased estimator will make errors that will largely cancel one another out. A biased estimator will do no such thing»

But the consequences in a dynamic system with path dependency are not necessarily all that different: when policy driven by the unbiased estimator is too loose or too tight one year, that changes the situation in all subsequent years, and the unbiased estimator the next year will be wrong the opposite way, but the effect won't "largely cancel each other out". The difficulty of ciourse is that "the economy" is not one "population", but a series of "populations"...

«Fed estimates over the last seven years have consistently been overly-optimistic.»

That's only according to one reading. Asset prices have been booming, as dictated by the real mandates of the Fed, to guarantee the profits of the financial sector and to keep asset prices growing.

Because central bankers have "decided" that wage-inflation is bad (the myth of the "wage and price spiral", nobody calls it the "commodity-profits and price spiral"), but profit-inflation is good, and have been working hard to redistribute gains from inflationary wages to non-inflationary profits with the cooperation of fiscal policy.

[Blissex]

«Commercial banks then either compete, or go bust. Either is fine. [ ... ] Cut out the middleman and have more direct control.»

Frim the point of of view of the City that is advocacy of communism, that is a call to armed revolution :-).

Be realistic...

[nick ford]

As Rumsfeldt said:
Some errors are inevitable.
And it is inevitable there will be some errors.
But it is not inevitable some inevitable errors will not in fact be errors.

[Blissex]

«central bankers have "decided" that wage-inflation is bad [ ... ] but profit-inflation is good»

For a more euphemistic yet quite interesting discussion of this central bank policy here is a good post by SR Waldman 2009-10-27:

http://www.interfluidity.com/v2/213.html

[Richart Ruddie]

One that I like to invoke is instead of saying "No Worries" the term "All Good". Getting rid of negative words and replacing them with positive terminology has been very beneficial in living a positive life.

I owe a special thanks to my friend Ben who turned me onto this.

[Bob]

Blissex, outside of London that seems perfectly reasonable ;)