Central Bankers Face a Crisis of Confidence as Models

The title of this week’s commentary is the title of an FT article published at the end of last week as monetary authorities gather in Washington for the annual meetings of the IMF and World bank. It would appear that the mood is somewhat subdued…central bankers are puzzled as to why inflation is not rising as much as their models suggest. To quote the FT;

“As they gather in Washington for the annual meetings of the International Monetary Fund, there is a crisis of confidence in central banking. Their economic models are failing and there are doubts whether they understand the effects of interest rates and other monetary policies on the economy…In short, the new masters of the universe might not understand what makes a modern economy tick and their well-intentioned actions will prove harmful.”

Link to article here.

What we find even more amazing is that despite their growing lack of faith in their models (models that the FT describes as fiendishly complicated), some central bankers still believe that forward guidance (aka simple jawboning) is an effective policy tool even when they are worried that their fiendishly complicated models are not up to scratch. Let’s just say we’re sceptical on this front. In fact, we’re pretty sceptical whenever a central banker speaks nowadays, as they are often self-serving, duplicitous and completely ignorant of the unintended consequences which we truly believe are yet to be seen from their audacious monetary policy experiments of the last decade.

A number of central bankers were either speaking publicly or being interviewed by the media in Washington. Outgoing Fed vice chair Fischer said the US has room for more investment and consumption. Dallas Fed president Kaplan said that business activity was strong and the consumer was in good shape. St Louis Fed president Bullard said financial market risks not extraordinarily high at the moment…to cherry pick just a few. These comments, along with some other research on the looming pensions crisis (ie tens of trillions of dollars in off balance sheet liabilities waiting to hit in the coming decades) prompted us to do a little digging around in the US national accounts.

We continue to think that imminent (next two or three quarters) risks of recession are low (famous last words!), but we are see the current economic performance as very sub-par. We also worry about the quality of growth and the inequality that seems to worsen on a monthly basis. On the surface, the consumer is spending a lot. The first chart below shows consumption and household savings as a per cent of GDP. Between 1950s and the early 1980s, consumption was fairly steady around 59% to 62% of GDP, since which time it has steadily increased to the current level near 70%. So if record consumption is indicative of a consumer in good shape, then Fed president Kaplan is correct. It is also possible that the share of consumption continues to increase, in which case vice chair Fischer is correct. But is this good economic management?