CENTRAL BANKERS SHOULDN´T YEARN FOR GOOD OLD DAYS THAT NEVER EXISTED: FED CONFERENCE PAPER / THE WALL STREET JOURNAL

Central Bankers Shouldn’t Yearn for Good Old Days That Never Existed: Fed Conference Paper

Economists argue against looking for simple and straightforward solutions to monetary-policy challenges

By Ben Leubsdorf

Aug. 29, 2015 10:00 a.m. ET


The economy is far too complex to be described by simple mathematical models and equations, and the world’s central bankers shouldn’t seek to return to a mythical past when monetary policy was a straightforward affair, two economists argued in research presented Saturday at the Federal Reserve Bank of Kansas City’s annual economic symposium in Jackson Hole, Wyo.

“This paper offers no simple or straightforward way to deal with the issues we present,” Johns Hopkins University economist Jon Faust and Indiana University economist Eric M. Leeper concluded. “Our only robust advice at this point is that we should stop looking for simple and straightforward solutions to the challenges that monetary policy poses.”

The former Fed economists contested the idea that, before the financial crisis, central-bank policy makers could rely on mathematical models of the economy to accurately predict the behavior of inflation and output and then use simple rules to help set monetary policy.

They quoted a 2013 speech by European Central Bank President Mario Draghi, who said “there was a time, not too long ago, when central banking was considered to be a rather boring and unexciting occupation,” when “inflation was tamed and macroeconomic volatility was contained” and “some thought that monetary policy could effectively be placed on auto-pilot.”

They said that the very idea of policy “normalization,” as the Fed describes the process that includes raising short-term interest rates that have been pinned near zero for nearly seven years, is a comforting one that implies returning to a normal state of affairs.

But traditional ways of understanding inflation dynamics often don’t incorporate myriad variables that can complicate the price and wage picture, such as fluctuations in productivity and output growth across economic sectors and divergences between inflation rates for various goods and services, Messrs. Faust and Leeper wrote. Academic economists and central bankers are aware of such complexities, they wrote, but their simplified economic models don’t take them into account.

“The conventional view of normal cyclical dynamics has historically been of essentially no value in predicting inflation dynamics,” they wrote.

They also took a shot at Taylor rule-style attempts to develop equations to help determine the appropriate stance of monetary policy, at a time when some House Republicans have proposed requiring the Fed to adopt such a policy rule. “There has been no clear historical episode of any appreciable duration in which simple Taylor-rule like behavior resulted in benign outcomes,” they wrote.

They wrote that policy makers must try to understand economic forces in all their complexity, formulating and communicating policies on that basis.

“We will not return to the policy as mythologized during the [period from 1995 to 2005]—the myth that normal cyclical dynamics are relatively benign and some simple rule captures the essence of good policy,” Messrs. Faust and Leeper wrote. “We cannot return to that world because it never existed. Our reading of history is that understanding disparate confounding dynamics has always been the key to good policymaking and failure to understand those dynamics has played a key role in major policy mistakes.”

The paper, “The Myth of Normal: The Bumpy Story of Inflation and Monetary Policy,” was prepared for the Kansas City Fed’s Jackson Hole conference, which began Thursday and ends Saturday.