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In this week’s Grumpy Economist Weekly Rant, John Cochrane examines one of the central challenges facing the Federal Reserve under Kevin Warsh’s leadership: how to make policy when forecasts and models remain deeply uncertain. Cochrane argues that the Fed’s inflation forecasts have repeatedly proved unreliable, from misplaced expectations in 2016 to the belief that inflation would fade quickly in 2021 and 2022.
Cochrane distinguishes between forecasts, which try to predict what will happen, and models, which are better suited to asking “what if” questions about policy choices. But both, he argues, have limits. When central bankers do not fully understand the forces driving inflation, monetary policy should be guided by caution, evidence, and the capacity to respond decisively to events rather than relying too heavily on uncertain predictions.
Transcript
Hi, I’m John Cochrane. I’m a senior fellow here at the Hoover Institution, and welcome to The Grumpy Economist Weekly Rant.
Today, I’m going to think about more challenges for the Fed under Kevin Warsh’s new leadership. Do we know how this works?
Warsh has rightly pointed out that the Fed’s models and forecasts are very unreliable, and he wants to think about how to make those better. That’s absolutely true. The Fed’s forecasts have failed many times. Now, maybe inflation is ultimately unpredictable, and no one can forecast it. That’s worth thinking about, but it is true that the forecasts the Fed relies on have fallen short.
The Fed thought inflation was going to come in 2016, swiftly raised rates, and it didn’t come. Throughout the inflation of 2021 and 2022, the Fed’s forecasts kept saying inflation would go away. It didn’t, and the Fed was lulled into complacency. Last summer, the Fed thought inflation would swiftly go back to 2% and started easing on that forecast.
Inflation is now resurging. The forecasts are unreliable; let’s face that.
Models ask a different question. They don’t say what will happen. They answer “what if” questions. If the Fed raises interest rates, what happens to interest rates? The models are even more unreliable.
The one thing I can tell you with great authority, having studied this for 40 years, is nobody really knows how the thing works. There is a chasm between the verbal doctrine that central bankers espouse — higher interest rates, lower demand; lower demand lowers inflation — and the equations of the model that capture solid economics work.
The equations think about multiple equilibria and a sort of game theory. Either people are really dumb, which justifies the Federal Reserve’s thinking, or we live in that strange multiple-equilibrium land that nobody really believes.
Data and evidence — those are weak, too. The empirical estimates we have say that higher interest rates slowly lower inflation, maybe over a couple of years.
The one piece of evidence going into those estimates is 1980. Interest rates went up, inflation went down, and a lot of other things happened.
We know even less about the balance sheet. The balance sheet is a big item under discussion: should the Fed reduce or raise its balance sheet? In simple theory, once reserves are abundant, more or less doesn’t matter at all.
Reserves are like oil in a car. If you have enough oil in the car, pouring more oil in the car doesn’t make any difference; it just makes a little mess all over the driveway. If you have too little oil in the car, yeah, the car slows down, and that’s a terrible way to slow down a car.
Are there more frictions? Maybe. Who knows?
So what do you do when you don’t know? Well, you try to find out, but we’ve been at it for decades, and let me tell you, I work on this. It’s really hard.
I think wisdom, when you don’t know, is not to trust the forecast too much. Surely, preemptive movements because forecasts say one thing or another, or because models say one thing or another, are dangerous.
It’s probably better to wait until you see the whites of their eyes, as the saying goes, and react carefully to events rather than forecasts or models.
It also requires flexibility. “Whatever it takes,” said Mario Draghi to quiet the euro, and that’s right. Explain to the public that you’ll do whatever it takes, and that will quiet the expectations which underlie a good deal of volatility and inflation.
It’s difficult to act in a time of uncertainty, but there is some wisdom about how to act when things are uncertain.
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John H. Cochrane is the Rose-Marie and Jack Anderson Senior Fellow of the Hoover Institution at Stanford University. An economist specializing in financial economics and macroeconomics, he is the author of The Fiscal Theory of the Price Level. He also authors a popular Substack called The Grumpy Economist.