Sunday, January 29, 2012

The Artist Replies

In his post complaining about John Cochrane, Brad DeLong says
The problem is that there are a lot of influential bullshit artists out there. Cochrane is at least willing to try to engage. Lucas, Fama, Prescott, Posner, etc., etc. are not even willing to do that.
Seems to indicate some desire to engage with people on discussions concerning serious economic questions of the time, right? Wrong. In response to my appeal for engagement (combined, you might add, with some mild admonishment), DeLong responds with this old news, from 17 months ago. So much for that. This is my family's favorite joke, actually. Second-stupidest man alive. Always gets a good belly laugh around the dinner table.

Speaking of jokes. It's a little late for college admission essay-writing, but here's an essay assignment. Suppose your plane crashes in the mountains. You're trapped in the snow and have been waiting months for help. You have eaten all the food, and have long since abandoned the taboo on cannibalism. Brad DeLong and Newt Gingrich are on the plane, and both alive and well. Which one do you eat first? 200 words or less.*

Addendum: Seriously, though. Krugman in particular wants to propagate the view that what he calls "freshwater macroeconomics" (which has actually ceased to exist, but whatever) is hermetically sealed and unwilling to engage. DeLong seems to feel the same way. Thoma fancies himself to be an open-minded individual, but goes along. Why am I singling those three out? They seem to lead the Old Keynesian blogosphere. If you are an economist and interested in blogging, in a way that might be controversial from the point of view of those three people, don't think they want to engage. They do not. Their interest is in reverse-engineering policy recommendations, not in thinking seriously about new ideas. Their arguments consist of calling people stupid and/or making out that their opponents are somehow morally reprehensible. They are engaged in political journalism, not economic discussion.

*Let me explain further, in case you don't get it. The whole situation is totally disgusting, in many ways, just like this blog exchange. But you're faced with a quandary, and have to weigh the costs and benefits. There are the costs and benefits to society. There are personal costs involved. You're going to have to sit in the snow for a long time with the one who lives, and they are both REALLY hard to be around.

Brad DeLong: B.S. Artist

Old Keynesians with blogs seem to have an unhealthy obsession with John Cochrane. Maybe it's his boyish charm. Who knows?

At the head Mark Thoma's daily list of writings-that-Mark-agrees-with is this post by Brad DeLong.

DeLong makes two points:

1. He seems to think that John has changed his mind about "stimulus spending," and quotes from Cochrane's blog post to try to make the point. If you actually read Cochrane's blog post I don't think you will come away with the same impression. I certainly did not. Here's a section:
The "stimulus" proposition is that additional spending -- whether needed or not -- raises output and general welfare. Pay people $1 to dig ditches and fill them up again, and the whole economy gains $1.5. Yes, endorsed by Krugman because it "feels like a job" (his back must not hurt like mine does) and by DeLong: "anything that boosts the government's deficit over the next two years passes the benefit-cost test--anything at all."

The "targeted," "infrastructure," and the whole worthy apparatus to monitor the wisdom of "stimulus" spending (see John Taylor) is, in the Keynesian model, beside the point, or at best a smokescreen to befuddle the ignorant masses. It would in fact be better if the money were stolen. Thieves have high marginal propensity to consume, and they can get that "spending" out fast in an economy with few "shovel-ready" projects.

Stimulus is a remarkable proposition, because micro fallacies morph into macro wisdom. We all lambaste mayors who tax small businesses (or borrow against future taxes) to build showpiece "jobs" projects. This way lies Buffalo. Yet for the economy as a whole, stimulus says, it's true. The hurricane should have been bigger, so the government would have spent more money to rebuild. Many stimulus advocates point to WWII spending. Think about what that means: all those tanks, ships, and airplanes on the ocean floor were not a terrible economic sacrifice we paid to win a desperate war. Every ship the Germans sunk let the government buy another ship, and gain a ship and a half worth of GDP in the process!
Hardly a pro-stimulus guy, I think.

2. DeLong seems to think that John's statements on public policy somehow ruined the 2008 stimulus package:
Perhaps Cochrane misled Michael McKee and Oliver Staley because he had simply not done his homework--had not thought the issues through at an Econ 1 level. Perhaps he was playing for Team Republican and knowingly telling them lies when they called him up and asked him about Jim Tobin.

I really don't care which.

What I do know is that his intervention made Christina Romer and Larry Summers and company's technocratic job more difficult at a crucial moment.
Well boo-hoo. The key problem with the stimulus was that, in fact, it was driven by Econ 1 thinking. That's the way that Brad DeLong and Christina Romer think. At best they are doing IS-LM, but mostly this is Keynesian Cross. There are plenty of good reasons why that just does not cut it. We can do a lot better. Any student educated in a top PhD economics program today has much better tools to address the question of what the fiscal authority should do in a recession. Cochrane is not perfect, but he's thinking about the right things.

Here's my recent thinking about the general issues at stake. I'm pretty much in agreement with Jim Bullard, though we may differ on some of the monetary policy issues. Bullard argues, basically, that Friedman and Mankiw were right. Fiscal policy is mainly about the long run. We should decide how large the government should be and what it should do, and there should be essentially no discretionary countercyclical fiscal actions. That doesn't say that we can't have appropriate social insurance - what some people would call "automatic stabilizers," such as unemployment insurance - that imply greater transfers, for example, in a recession than in a boom. Or, as Cochrane points out, there may be sound reasons - tax-smoothing for example - that imply that we should run a deficit during a recession and a surplus in a boom.

Finally, DeLong finishes with this gem:
The problem is that there are a lot of influential bullshit artists out there. Cochrane is at least willing to try to engage. Lucas, Fama, Prescott, Posner, etc., etc. are not even willing to do that.
I'm wondering who those "influential bullshit artists" are. Honestly, I have no idea what he is talking about. I'm also wondering why he's picking on Lucas, Fama, Prescott, and Posner. Those people are all septuagenarians. Personally, I'm quite happy that Lucas and Prescott are still engaged in what they do well. They regularly talk about economics in public, and participate in academic conferences. They are both a pleasure to talk to - I learn something from Bob and Ed whenever I see them. What more do we want from those guys? We want them to write blogs? What for? Fama and Posner are not even macroeconomists. Who gives a crap what they think of the stimulus package?

Well, Brad. I'm here and willing to engage. What's on your mind?

Saturday, January 28, 2012

Lacker Dissent

Jeffrey Lacker explains his dissent on the recent FOMC decision in this press release. He says:
"I dissented because I do not believe economic conditions are likely to warrant an exceptionally low federal funds rate for so long. I expect that as economic expansion continues, even if only at a moderate pace, the federal funds rate will need to rise in order to prevent the emergence of inflationary pressures. This increase in interest rates is likely to be necessary before late 2014.

"In addition, the Summary of Economic Projections (SEP) now contains detailed information on the forecasts of Federal Reserve governors and Reserve Bank presidents for the evolution of economic conditions and the federal funds rate under appropriate policy. My dissent also reflected the view that statements about the future path of interest rates are inherently forecasts and are therefore better addressed in the SEP than in the Committee's policy statement.
His reasoning, which I agree with, is that the Fed is going to get itself in trouble by making the commitment that it did, and that any useful foreward guidance we might get from the policy statement is already in the SEP, without the bad commitment.

Friday, January 27, 2012

Optimal Inflation

Paul Krugman takes issue with the Fed's now more-or-less-explicit long-run inflation target of 2%. He thinks it should be 4% or 5%.

Here's the offending part of his blog post:
But why is the inflation target only 2 percent?

Actually, I understand why; the inflation hawks are still a powerful force that must be appeased. But the truth is that recent experience has made an overwhelming case for the proposition that the 2 percent or so implicit target prior to the Great Recession was too low, that 4 or 5 percent would be much better. Even the chief economist at the IMF says so. (OK, in real life it’s Olivier Blanchard, who is a very smart and also flexible-minded macroeconomist who just happens to be at the IMF for now — and I’m glad that he is!)

1. The "inflation hawks" are NOT a powerful force on the FOMC. The Committee just voted, with one dissenting vote, to keep the target for the fed funds rate in the range 0-0.25% until the end of 2014. That's hardly a hawkish policy, and the Fed has already engaged in some massive and unprecedented quantitative easing, that is far from hawkish and conservative. Indeed, it is quite risky, and favored by the majority of FOMC members, who are basically old and new Keynesians, if they know any economics at all. Actually, the moniker I would prefer to apply to the "inflation hawks" is "serious economists" (for the most part - Fisher is not an economist).

2. The Blanchard paper that Krugman is referring to is this one. Here is what it says about the central bank's inflation target:
The crisis has shown that large adverse shocks can and do happen. In this crisis, they came from the financial sector, but they could come from elsewhere in the future—the effects of a pandemic on tourism and trade or the effects of a major terrorist attack on a large economic center. Should policymakers therefore aim for a higher target inflation rate in normal times,
in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent?
The paper goes on to discuss the costs of the inflation, in more-or-less standard textbook terms. There's nothing new there. So, did Krugman actually read the paper or not? It doesn't really matter. The key point is that Blanchard is not recommending anything, he's just asking a question. There's no report on any research to answer the question; this is just Blanchard musing with his staff about how recent history might change how we think about monetary policy. Thus, Krugman's statement that "Even the chief economist at the IMF says so," is false.

But what of Krugman's argument? Krugman says (repeating the above):
But the truth is that recent experience has made an overwhelming case for the proposition that the 2 percent or so implicit target prior to the Great Recession was too low, that 4 or 5 percent would be much better.
He certainly seems convinced; "truth" and "overwhelming" are strong words. It's hard to see why, though, and he doesn't tell us. If you read Blanchard's paper, and look for the reasoning, you might see what Krugman has in mind. The basic idea is that a higher inflation rate gives the central bank more room to move. By Fisherian logic, if the real interest rate is constant in the long run, and the long-run Fisher effect holds, the long-run nominal interest rate will rise one-for-one with the long-run inflation rate. Having more room to move means that, if you subscribe to New Keynesian logic, then if the long-run inflation rate is 4% rather than 2%, on average you have an extra 2% by which you can lower the central bank's nominal interest rate target so as to correct sticky price distortions. There are at least 3 problems with this:

1. This presumes that the long-run costs of inflation are negligible, but to me this looks like an argument for wearing a sweater in July. You can always take it off if you want to cool down. I have written more on the costs of inflation here. Potentially the long-run costs of inflation are much larger than conventionally measured. Anyone who lived through the 1970s or, even better, comes from a country with a serious inflationary history, understands that inflation is bad.

2. If the key macroeconomic inefficiencies we are faced with are the relative price distortions coming from sticky prices, those inefficiencies might more appropriately be corrected with fiscal policy than monetary policy. Krugman seems to be thinking that the zero lower bound is a big problem, but the zero lower bound need not bind.

3. Blanchard, like Krugman, seems to fear the zero lower bound because bad stuff can happen there. Well, we have been in our modern-day liquidity trap for more than three years now, and apparently we have not yet been sucked into the deflationary vortex with ever-increasing output gaps that these characters seem to be concerned with.

Wednesday, January 25, 2012

The FOMC Sticks Out Its Neck - Again

The FOMC meeting that took place over the last two days was an important one. The first big piece of news is in the FOMC statement in this paragraph:
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.
The previous statment from December read as follows:
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
So, policy is now to be more accommodative. Presumably something changed. Somehow the state of the world must look worse in some unexpected way on dimensions the Fed cares about. What could it be? In the first paragraph of the current statement, we learn that the recovery is proceeding, perhaps more slowly than might have been anticipated a year or two ago, but maybe a little more quickly than was expected at the last FOMC meeting. Inflation has decreased slightly, but the Fed had expected that, and the inflation rate is increasing in terms of core measures. So why the policy change? Why indeed?

This is a very risky policy move. By the end of 2014, the interest rate on reserves (IROR) will have been at 0.25% for more than six years. The Fed has never made such a commitment before, and they have no clue what will happen as a result. Here is what could happen. Months from now, a year from now, or whatever, banks may get the idea that bank reserves are a less attractive asset to hold. That would be triggered by better relative returns on alternative assets, which in turn could simply be the result of an ultimately-self-fulfilling higher inflation rate. Banks will start to abandon reserves and prices will rise. What should the Fed do under those circumstances? It should increase the interest rate on reserves to curb the inflation. But it committed today not do that. Everyone understands this, and that's what will get the inflation going. Once higher inflation really becomes entrenched, it's hard to get rid of. How do we get rid of it? Well, we know all about that, as some of us had to live through it in the early 1980s. Time for another recession.

This is a replay of the August 2011 decision, except worse. Recall that Fisher, Kocherlakota, and Plosser were opposed on that round, and note that Lacker dissented this time around. Kocherlakota's argument for dissenting last August was that the policy change was inconsistent with the FOMC's previous behavior, and the same argument applies here. Best guess is that Fisher, Kocherlakota, Plosser, Lacker, and perhaps others, are opposed this time around. That would be a serious disagreement, with some astute economists on the nay side.

The FOMC also released a statement that is supposed to clarify how it thinks about policy. This is notable in at least two respects. First, the FOMC is expanding the dual mandate:
The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates.
"Maximum employment" crept into the FOMC's language in recent times, but now they are entering into new territory by taking ownership over long-term interest rates. Here, the first law of central banking comes into play: Don't take responsibility for something you cannot control. A central bank controls an overnight interest rate, and any interest rate - like the interest rate on reserves - that it sets administratively. Sometimes, like now, that amounts to the same thing. Though in pre-Accord times the Fed could successfully peg long-term bond rates, it would be incorrect to say that this can be done under typical conditions. Indeed, under current conditions, though the Fed seems to think that its quantitative easing (QE) operations can move long bond rates, it is fooling itself.

The second piece of important information in this latter statement is:
The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.
So now we have an explicit statement that the Fed's inflation target is 2%, as measured by the rate of change in the pce deflator (raw). That's not an explicit inflation target, as they make it clear that the dual mandate applies - they will tolerate more inflation if employment is lower than "maximum employment," whatever that is, and vice-versa.

The Fed is now also releasing more information on its forecasts, available here. These seem pretty optimistic on the inflation front. FOMC participants are not only forecasting close-to-zero short-term nominal interest rates for years in the future, they are also forecasting inflation rates well below 2% for three years and more into the future. I would love to see the models (and the add factors) that produce those forecasts.

Here's what we see in the data. The chart shows the pce deflator, the Fed's preferred price level measure, going back to January 2005, as compared to a 2% trend beginning at the same time. In level terms, we are now on the high side by about 2%. You have to be creative about the base period to find a case where the actual pce deflator is below the 2% growth path. Thus, it's hard to say that inflation is too low relative to its 2% target path. Given recent history, and the projection for monetary policy the Fed is going on, how could anyone be predicting inflation rates as low as 1.5% over the next several years? You tell me.

Here is another piece of information that will either make you laugh or cry. The release of information about the Fed's forecast was supposed to give us some inside information on what the Fed is thinking so that we can feel more secure. In Figure 2 of the forecast summary, we see when the FOMC participants predict "policy firming." Six participants seem more-or-less sensible, and are predicting firming in 2012 or 2013. But there are another six who are not predicting firming until 2015 or 2016. Now I'm not feeling more secure. I want to panic, because those people seem to be incompetent.

Wednesday, January 18, 2012

Economics is an Open Science

Here's an article in the NYT which tracks a trend in the natural sciences and medicine (mainly) toward more open evaluation and discussion of scientific contributions. As Paul Krugman points out, economics has always been an open science, at least within the professional lifespans of people as old as Krugman and me. Even prior to rapid electronic communication, economic research was widely-circulated in working papers and at conferences and seminars prior to publication. The results were hashed over, reworked, and amended, with the ultimate published articles typically acknowledging the contributions of many other scholars on the road to completion. Publication was, and is, essentially a grade given to the work, i.e. a publication in the American Economic Review, Journal of Political Economy, or Econometrica, is A+, and you work down from there. Email communication and the internet served only to speed up the process and make work even more widely distributed. No more waiting for the Minneapolis Fed working papers in the mail.

As the NYT article tells you, things are not like that in the natural sciences or in medicine, for example, often because there are potentially large monetary gains and losses riding on the results. Natural scientists think that it is quite odd for anyone to be talking in public about their research results before they are published. Economic research can have very large implications for human welfare, but the path from a given research result to its effect on the public is typically so indirect and diffused, and the benefits so large to an economic researcher from claiming credit early for a given result, that no one is going to hide their work until it is published.

According to the NYT article, some scientists are complaining that the whole process of peer review and publication is "hidebound, expensive, and elitist." Do we have any of those problems in economics? I think "expensive" certainly applies, and the culprits in economics are the same ones as in the natural sciences. The NYT article states:
The largest journal publisher, Elsevier, whose products include The Lancet, Cell and the subscription-based online archive ScienceDirect, has drawn considerable criticism from open-access advocates and librarians, who are especially incensed by its support for the Research Works Act, introduced in Congress last month, which seeks to protect publishers’ rights by effectively restricting access to research papers and data.
Elsevier in fact owns many economics journals, and is well-known for extracting rents from libraries and subscribers. In the old print days, a publisher could provide useful services. Typesetting, printing, binding, and distributing print journals was a specialized task subject to increasing returns. Do publishers provide any value-added in 2011? Absolutely not. But as the article points out, publishers like Elsevier would like to pass laws like the Research Works Act that will allow them to continue to collect rents and impede the dissemination of scientific knowledge.

So, the expense of publication is a problem in economics. But is scholarly publication in economics "hidebound and elitist?" Krugman thinks so:
I have a somewhat jaundiced view of how the whole refereeing/publication system has ever worked; all too often, it seems to act as a way for entrenched doctrines to blockade new ideas, or at least to keep people with new ideas from getting tenure at a good school.
I'm going to disagree with Krugman here - not for the first time, of course. Editors, referees, and the economics profession can make mistakes. Sometimes it takes a while for us to catch on to a new idea and recognize what is important about it. Here's a good example. Expectations and the Neutrality of Money was rejected for publication by top journals (the American Economic Review, at least, as I remember the story), and published in the Journal of Economic Theory, at that time a relatively new journal with essentially no reputation. That article now has more than 3000 citations on Google scholar, was part of what Robert Lucas received a Nobel Prize in Economics for, and changed the methodology of macroeconomics in a rather dramatic way. The east coast economics establishment hated Lucas's paper (as Krugman still does) but that didn't stop the ultimate recognition of the work. For every inbred group of scholars eager to keep outsiders out, there are 5 journal editors who would be more than happy to publish new and pathbreaking work.

What about the blogosphere? Do blogs contribute to economic science? They certainly could, but most blogging on economics, including mine, is journalism. I'm very pleased that I don't have to acquire space in the Washington Post, the Wall Street Journal, or the New York Times to speak my mind, but I don't think that what I do here is serious science. Serious economic science is what is published in the top economics journals.

Fed Salaries

This New York Times article is interesting. The author argues that the Fed now looks like a hedge fund, but Fed officials are not paid like hedge fund managers, and it goes from there.

This part is not quite on track:
The main difference between a hedge fund and the Fed is that the Fed effectively creates its own money, so it doesn’t have any borrowing costs, meaning yet more profits.
This is effectively the "creating money out of thin air" argument, which many people are confused about, including Sarah Palin. All financial entities create liabilities out of nothing, and buy assets. That is certainly not a distinguishing feature of the Fed. What makes the Fed different is its monopoly on a particular kind of circulating liability - currency. Otherwise, the Fed is a financial intermediary which issues liabilities - mainly currency and interest-bearing reserves - and holds assets. Why the author of the NYT article thinks the Fed looks like a hedge fund is that it intermediates across maturities, and much more so recently. The average duration of the assets in the Fed's portfolio has lengthened considerably since the financial crisis. Intermediating across maturities is considered risky, just as operating a hedge fund is risky. However, in the case of the Fed, the risk is borne by taxpayers. If short-term interest rates increase, then the Fed's profits fall, so the Fed has less to hand over to the Treasury, which has to make up the difference.

There are also some things in the NYT article about Fed salaries, which are certainly low relative to hedge fund salaries. Further, Fed salaries of top officials in the Fed can be lower than academic salaries. Ben Bernanke was probably earning more at Princeton than he is in Washington.

Here's a useful point:
Even so, people in private industry argue that you have to pay top dollar to get the best people and that the market demands it.

We even see this argument being made by the federal government. The regulator who oversees Fannie Mae and Freddie Mac, Edward J. DeMarco, has asserted that he had to pay the top six executives at Fannie and Freddie more than $35 million in combined pay over 2009 and 2010. He said that to do otherwise would be “irresponsible” because it would fail to retain and attract the appropriate people. Yet, the Fannie and Freddie executives are arguably doing even less sophisticated work than the Federal Reserve employees do.

Why these executives should be paid more than Mr. Bernanke and his colleagues defies reason. This is government work now.

We are the 1%

From this New York Times blog post, if you are choosing among undergraduate majors and want to be in the top 1% of the income distribution, taking economics would be a good idea. Only the pre-med students did better in this respect.

Friday, January 13, 2012

Bullard's "Death of a Theory" Paper

Jim Bullard has posted his "Death of a Theory" paper here. This is essentially a call for a return to pre-financial-crisis views of the relative efficacy of fiscal policy and monetary policy for stabilization. Before the financial crisis, even New Keynesians were primarily focused on monetary policy. Mike Woodford's "Interest and Prices," for example, is almost exclusively a handbook on monetary policy. The views of New Keynesians on fiscal policy seemed to have been more or less consistent with those of Milton Friedman. Fiscal policy matters, but fiscal policy is about the long run. The process of making fiscal policy decisions is awkward and time-consuming, and we know little enough about how the economy works that stabilization using fiscal policy is inappropriate.

Things have changed since the financial crisis, however. Governments have been putting fiscal policy to use for stabilization purposes, and New Keynesians have jumped on the bandwagon. Bullard's paper argues, in light of the evidence and the economics literature, that the pre-financial crisis view is entirely appropriate, i.e. fiscal policy should focus on the long run and leave the short run to the central bank. Bullard says:
In short, existing political processes are, generally speaking, far too cumbersome and contentious to enact effective and timely short-term actions in response to market events. They are ill-equipped to deliver the types of subtle tax and spending interventions that may actually be effective according to a careful reading of the available macroeconomic literature on the topic.
Here's part of what the content of the paper is about:
I will describe and comment on two strands of the macroeconomic literature in this area, one highly formalized and the other intuitive but rhetorically potent. The …first is the heavily studied fi…scal multiplier idea in the context of New Keynesian DSGE macroeconomics. The second is less studied and not formally articulated very often. It is that a substantial increase in de…ficit-financed government purchases sends a signal to the private sector that a high growth regime is possible— and likely— going forward. This could infl‡uence private sector expectations and lead to a virtuous equilibrium in which actual output and employment are high. Rhetorically, this seems to be what many advocates have in mind, even if this is not what happens inside most of the macroeconomic models used to analyze this issue.
This is interesting, as it highlights an aspect of policy recommendations coming from hardcore Keynesians - Krugman for example - that do not make clear what the underlying source of inefficiency in the economy is. From a Keynesian point of view, the inefficiency could be sticky wages and prices, on the one hand, or a coordination failure, on the other. What the policy response should be depends on the inefficiency, though not every Keynesian understands this. As Bullard states, the type of coordination failure that some Keynesians appear to have in mind - self-fulfilling beliefs about the future driven by fiscal policy - has not really been formally studied.

Thursday, January 12, 2012

Alan Krueger Tries to Justify Income Redistribution

Here's a speech from yesterday by Alan Krueger, on income distribution. It's clear this is an attempt to provide some economics to support the ideas in a previous Obama speech. Maybe we should not give Krueger a hard time about his speech, as he is just out there doing his job. However, I think honesty and good economics are important, so let's see what Kreuger has to say.

It is by now well-known that there has been an increase in the dispersion of income in the United States, beginning perhaps as early as 1970. Krueger discusses this, but he also wants to make the case that there is less mobility across the income distribution than there once was, and less mobility in the United States than in other countries. Kreuger cites as evidence some work by Miles Corak at the University of Ottawa. Corak's "Great Gatsby curve" which shows a positive correlation between income inequality and immobility across levels of income within a country. Of course, this only establishes a correlation that exists in the data. Kreuger is making a policy speech. What we really care about in this instance is the effects of particular policies. To evaluate those, we need a serious structural model on which we can run experiments to evaluate alternative policies and compare their effects on economic welfare.

Krueger tells us about some of the causes of the increase in income inequality in the United States. This is pretty standard, though he has a funny way of assembling the evidence:
In the mid-1990s, I did a poll of a nonrandom group of professional economists attending a conference at the New York Fed. I asked them the extent to which various factors contributed to the rise in inequality.
Hopefully everyone understands why it is a bad idea to take a poll among economists to get a serious answer to any question. If I want to understand why income inequality has increased in the United States, I will read the relevant peer-reviewed published research, sift the arguments, and then draw some conclusions. Fortunately, in this case Krueger actually came up with an answer that is consistent with the received research. If Krueger had asked the same group of people to each write down their estimate of the government spending multiplier, I can assure you that he would get nonsense.

As is well-known, there are three key factors driving the increase in income dispersion. These are technical change, the scarcity of skilled workers, and import competition. Krueger, for political reasons, wants to attribute some blame to the Bush (W) tax cuts, but I think it is well-recognized that the effect of the change in the income tax schedule in this instance is relatively minor. He also talks about union membership and the minimum wage.

Here's where he starts to go off the rails:
Now, I could see why someone could support tax cuts for top income earners if they had materially benefited the U.S. economy, but the macro evidence is clear that the economy did not perform better after last decade’s tax cuts than it did after taxes were increased on top earners in the early 1990s. I already showed you evidence that income growth was stronger for lower and middle income families in the 1990s than it was in the last 40 years overall. This next chart shows that there was more job growth in start-ups in the 1990s than in the 2001-2007 period [Figure 11]. Across all businesses, job growth was much weaker in the 2000s than in the 1990s. So there is little empirical support for the claim that reducing the progressivity of the tax code has spurred income growth, business formation or job growth.
It is well-known as a theoretical proposition that the income tax has negative incentive effects. The key question, though, is how large those effects are. For more on this see this previous post of mine, particularly the part on Diamond/Saez toward the end. I think one can make a case that the incentive effects are large, particularly in the long run. When Krueger points to the fact that the Bush tax cuts were followed by poor economic performance, we know that's not serious evidence, as there were too many other things going on over that period.

In the next part of his speech, Krueger wants to tell us about the harmful effects of inequality. This starts off OK, by appealing to our sense of fairness. Maybe this income inequality is denying people opportunities? We could be seriously misallocating resources if high ability poor people are not being educated while low ability rich people are going to Harvard. But Krueger comes up with some pretty strange ideas as well. The first strange idea he attributes to Raghuram Rajan, which is that high income inequality encourages "families to borrow beyond their means." I haven't read Rajan's book, but Krueger could be mischaracterizing Rajan's ideas. My understanding is that, rightly or wrongly, what Rajan is arguing is that government attempts to redistribute income, working in part through Fannie Mae and Freddie Mac, contributed to the financial crisis. Krueger makes Rajan sound more like Robert Frank, which involves a very different set of ideas.

The second strange idea, attributed to Robert Reich, is that the increase in income dispersion is bad because it reduces "aggregate demand," since high-income people save more than low-income individuals do. To buy this idea, you have to think that we collectively make the wrong consumption/savings decision, and that redistributing income from rich to poor will move us toward a better national allocation of income between consumption and savings. Imagine a world with two people. A has 5 banana trees and B has 20 banana trees. A spends all his working time picking bananas and eating them. B spends half of her working time picking bananas, and the other half of her time planting new banana trees and tending to them. Krueger thinks the world in which A and B live would be better if someone took bananas away from B and gave them to A. I have no idea why he thinks that.

So what policies does Krueger have in mind? The first is health care, which of course is already done, and scheduled to be fully-implemented by 2014. There is a clear redistributive aspect to the Affordable Care Act. Those who stand to benefit from it are the poor, and it will be paid for disproportionately (because of progressive taxation) by the rich. I know this is controversial, but I don't think it should be. The Act won't do anything much to deliver health care more efficiently in the United States, but I don't have a problem with it. I'm from Canada. A second thing he pushes has to do with the American Jobs Act, which again we know about already.

Krueger then gets into some controversial territory - the financial industry and taxation. First, Krueger says "we must adequately regulate excess risk-taking and corrupt practices in financial markets." No one would argue with that statement. Who wants too much risk-taking or corruption in financial markets? However, what does that mean? How do we know excessive risk-taking when we see it? What do we do about it? Financial firms are of course very good at hiding "corrupt practices." How do we root those practices out? How do we tell useful financial innovation from innovation that is there only to obfuscate and allow what is essentially theft? Some people want to put a tax on all financial transactions. But that seems too blunt a tool for correcting the actual problems.

Second, here's a tax proposal:
It also means that we can’t go back to tax policies that didn’t generate faster economic growth or jobs, but rather increased inequality. Instead of going backwards, we should adhere to principles like the Buffett Rule, which states that those making more than $1 million should not pay a lower share of their income in taxes than middle class families. We should also end unnecessary tax cuts for the wealthy, and return the estate tax to what it was in 2009.
We know what he means by "tax policies that didn't generate faster economic growth." He told us that those were the Bush tax cuts. It's not clear whether he wants to let the Bush tax cuts expire, or just have the top marginal rate revert to its pre-Bush era value. The difference matters, particularly for how this is sold politically.

It seems clear that Krueger knows the economics literature, as he should. The interpretation of some of the evidence is stretched, though.

Death of a Theory

James Bullard, St. Louis Fed President, has posted some slides for a talk at last week's ASSA meetings in Chicago. This seems to be a preliminary snapshot of a paper he is supposed to release this week. The topic is the relative efficacy of fiscal and monetary policies in the current circumstances. I'll write more on this when the paper is released.

Wednesday, January 11, 2012

Taylor Rules and the Fed

Greg Mankiw has a post on Taylor rule predictions and liquidity traps. Mankiw points out that, if you fit a Taylor rule to the data, that rule should soon give a prediction in positive territory. A common argument in the Fed system that has been used for a long time now (see for example this 2009 piece by Glenn Rudebusch) is that, since fitted Taylor rules predict a negative fed funds rate, the Fed should be taking some kind of unusual accommodative action, since of course the Fed is constrained by the zero lower bound on the fed funds rate.

Here's how John Williams, President of the San Francisco Fed, explains it:
We at the Fed have guidelines that allow us to set interest rate targets based on the levels of unemployment, inflation, and other economic indicators. So what do those guidelines tell us now? With inflation under control and unemployment so high, those guidelines tell us something most unusual: the federal funds rate should actually be in negative territory.

Of course, it’s not possible for the federal funds rate to go below zero, which is about where we’ve put it for the past three years. But that doesn’t mean that we are out of ammunition. We’ve created new ways to stimulate the economy. For example, we’ve purchased over one-and-a-half trillion dollars of longer-term securities issued by the U.S. government and mortgage agencies.
So, when our Taylor rule predicts a negative fed funds rate, apparently this tells us that quantitative easing (QE) is appropriate. Never mind that the model we are using (a New Keynesian model for Williams) does not tell us how QE works or how much of it we should be doing. Actually, no one has a serious model that can justify quantitative easing, though Williams wants to convince us that it's just Econ 101:
This policy works through the law of supply and demand. When we buy large quantities of securities, we increase demand for those securities. Higher demand equals lower interest rates. As the yields on longer-term Treasury securities come down, other longer-term interest rates also tend to fall. That reduces the cost of borrowing on everything from mortgages to corporate debt. Our securities purchases are an important reason why longer-term interest rates are at or near post-World War II lows.
It's simple! It's easy! It works!

What if we take the San Francisco Fed approach seriously. Mankiw's Taylor rule looks like this:

R = 8.5 + 1.4(i - u),

where R is the fed funds rate, i is the year-over-year inflation rate, and u is the unemployment rate, all in percentages. Of course the predicted value for R that we get given current data depends critically on the inflation measure that we use. Provided my arithmetic is correct, I get 1.4%, -0.3%, 0.1%, and -1.0%, if I use headline CPI, core CPI, PCE deflator, or core PCE deflator, respectively. So if I'm Mankiw, and I follow Williams's logic, it would be hard to make a case for QE3, for example, and I might want to start to think about raising the interest rate on reserves (IROR).

Alternatively, I could use a Taylor rule like Glenn Rudebusch's, which is:

R = 2.1 + 1.3i - 2.0G,

where G is the gap between the actual unemployment rate and the "natural rate." Here of course, the predicted value for R depends not just on the inflation measure we choose, but on what the natural rate is. For the contribution to R from the constant and inflation, if we use the four alternative inflation measures above we get numbers between 4.3 and 6.5. What is the natural rate? In New Keynesian parlance, that would be the unemployment rate in a world with flexible wages and prices. Hardliners at one extreme might think that in the flexible-wage-and-price world the unemployment rate would be what it was before the recession started, i.e. about 4.5%. In that case, the contribution from the gap would be -8.0. Hardliners at the other extreme might say that the outcome we are looking at is efficient, in which case the gap is zero, and there is no contribution from unemployment. Thus, our predictions could run anywhere from -3.7% to 6.5%. Maybe we should tighten. Maybe we should not. In any case, if we buy into this way of looking at things, it really does not tell us much. I think I could be a regular New-Keynesian Phillips-curve Taylor-rule kind of guy, and still be arguing for raising the IROR and arguing against QE3.

But there seem to be some people on the FOMC who want more accommodation. Not happy with a Fed balance sheet that has more than tripled in size, a policy rate at 0.25% until mid-2013, and new forward guidance about the Fed's intentions, Charles Evans is yelling for more. Recall that Evans has now been the sole dissenter on the FOMC in the last two meetings. The language in the FOMC press release has been:
Voting against the action was Charles L. Evans, who supported additional policy accommodation at this time.

What does Evans want and why?
The traditional course of action when inflation is below target and real output is expected to be below potential is to run an accommodative monetary policy. I support such accommodation today. And I believe the degree of accommodation should be substantial.
Note that this in not quite Taylor-rule language. He's saying that the forecast for real output matters - "real output is expected to be below potential." Two comments here:

1. Inflation is not below target, unless you cherry pick and take the core PCE deflator, which is running at 1.7% year-over-year. At the high end, headline CPI inflation is running at 3.4% - well above the Fed's implicit 2% target.
2. If you are recommending "accommodative" policy, you should have an idea what that means in the current context.

Evans and Williams are speaking more-or-less the same language on liquidity traps:
I believe that the disappointingly slow growth and continued high unemployment that we confront today reflects the fact that we are in what economists call a “liquidity trap.” Let me explain. In normal times, real interest rates—that is, nominal interest rates adjusted for expected inflation—rise and fall to bring desired savings into line with investment and to keep productive resources near full employment.

This market dynamic is thwarted in the case of a liquidity trap. That is, when desired savings increase a great deal, nominal interest rates may fall to zero and then can go no lower. Real interest rates become “trapped” and may not be able to become negative enough to equilibrate savings and investment. That is where we seem to be now—short-term, risk-free nominal interest rates are close to zero and actual real rates are modestly negative, but they are still not low enough to return economic activity to its potential.
That last sentence is very unconvincing. The zero lower bound is a problem in New Keynesian economics because it implies that you cannot reduce the real rate to the "Wicksellian natural rate." The real rate is thus inefficiently high in a liquidity trap. But it seems real rates are actually pretty low. Indeed, the five-year TIPS yield is down to -1.0%, and even the 10-year TIPS yield is negative. Evans seem pretty certain about what "low enough" real interest rates are, and what "potential" output is. I wish he would explain these things to us, so that we all know.

Finally, there are some arguments about why we should tolerate an inflation rate of as much as 3%, so as to escape from our liquidity trap. These arguments seem based on Ivan Werning's paper, which you can find on this conference program. The model in Werning's paper is essentially the 1970s version of New Keynesian economics - the stripped-down linearized two-equation version. There's an "IS curve" and a "Phillips curve," describing the trajectories for the inflation rate and the output gap, given the nominal interest rate, which is set by the central bank, subject to the zero lower bound. Then, evaluate how policy rules perform according to a quadratic loss function. But what's the optimal inflation rate? What's potential output? Werning's paper does not answer those questions, and those are the ones we need to have answers to.

For someone who is holding out on the FOMC for something more "accommodative," Evans is not telling us a lot about how he wants to do the accommodation. There's some stuff in there about how Fed policy should be much more explicit about addressing its dual mandate by setting numerical objectives for the unemployment rate, for example. However, it's unclear whether that is the key point of disagreement with the rest of the FOMC.

Wednesday, January 4, 2012

Small and Large Footprints: Reserves and the Fed

As most economists are well aware, financial institutions in the United States currently hold a very large stock of reserves - deposit accounts with the Fed. The first chart shows the stock of reserves for the last five years. Before the financial crisis, the primary role of reserves was as a means of payment among large financial institutions. Commercial banks of course have to fulfill reserve requirements, but given financial innovation that allows banks to essentially bypass the requirements, it is most useful to think of reserve requirements as irrelevant in the United States. Pre-financial crisis, a stock of $5 billion to $20 billion in reserves was sufficient to support all intraday financial payments and settlement in the United States. It is important to note that this small quantity of reserves was funding a huge quantity of daily payments. Indeed, in 2008, the average daily value of transactions on Fedwire (using reserves) was $2.7 trillion, so the intraday velocity of reserves is immense. It is important to take account of intraday credit extended by the Fed as well, which is essentially outside money created within a day that goes away overnight. In 2008, average daylight overdrafts (as within-day Fed credit is called) were about $62 billion.

Since the financial crisis, as can be seen in the chart, reserves have grown to the neighborhood of $1.6 trillion - more than 100 times the typical stock of reserves in the pre-crisis period. What implications does this have? During the financial crisis and shortly after, it was common for economists and Fed officials to discuss "exit strategies." The typical view was that we were in the middle of unusual circumstances requiring unusual monetary policy interventions, but that these interventions would eventually be unwound. Here's a speech that Charles Plosser made in September 2010. Plosser says:
As I have argued in past speeches, the Fed will need to shrink the size of its balance sheet toward pre-crisis levels and return its composition to all Treasuries.
This necessarily involves shrinking reserves outstanding to pre-crisis levels. Further, Plosser has some comments on reserves specifically:
There are two proposed mechanisms for implementing IOR [interest on reserves], both of which can impinge on central bank independence. One IOR operating mechanism is the floor system, in which the central bank sets its policy rate equal to the IOR. Under this framework, the central bank supplies enough reserves so that the banking system faces a perfectly elastic supply schedule of reserves.16 Under such a floor system, the Fed’s balance sheet is divorced from interest rate policy because an unlimited amount of reserves are available at the IOR-policy rate. Some have described the floor system as the “big footprint” central bank because its balance sheet can be large without directly affecting the monetary policy instrument, the IOR. Some think that this approach has advantages because it would enable the central bank to provide liquidity in a financial crisis without necessarily altering the stance of monetary policy.

The other IOR operating mechanism is the corridor system, in which the central bank’s policy rate is a market rate that is always between the rate charged at the discount window and the IOR. The corridor system does impose constraints on the size of the balance sheet because the supply of reserves would be set at a level that achieves the targeted interest rate. Thus, this might be called the “small footprint” central bank.
Thus, the system the Fed currently operates under is a floor system, whereby there is a large stock of reserves outstanding overnight, and the interest rate on reserves essentially determines the overnight interest rate (with some slippage in the United States due to GSE reserve accounts). the alternative system, the corridor system, is what the Bank of Canada currently adheres to. In Canada, reserves essentially go to zero overnight, and intervention by the Bank determines the overnight rate, which is higher than the interest rate on reserves and lower than the rate at which the Bank lends to financial institutions.

Plosser has some reasons not to like the "big footprint" floor system. Something I could add is that, under a corridor system the Fed gets current information on the daily shocks hitting the payments system and financial markets more generally. If the demand for overnight reserves rises or falls, the Fed has to intervene in the overnight market in order to achieve its target for the fed funds rate. If the same things happen under a floor system, this would have to be reflected somehow in the quantity of reserves outstanding, but there are currently many other factors, such as movements in and out of Treasury accounts, that also affect reserves. Maybe the Fed can untangle all these things; maybe not. The key problem is that the reserves are an accident waiting to happen. The Fed can always counteract higher inflation by increasing the interest rate on reserves under a floor system, but if it does not tighten when the appropriate time comes, the danger is a self-fulfilling expectation of higher inflation.

In my opinion, since quantitative easing is irrelevant under current conditions, one could reverse it with no effect. That is, the Fed could sell $1.6 trillion in Treasury securities and mortgage backed securities, reduce overnight reserves to some small amount on the order of what existed pre-crisis, and nothing much would happen. Then we would transit from a floor system to a corridor system.

There is another argument being made, though, as to why a big-footprint floor system might be a good idea. Unfortunately I can't find a link to this paper, but here are some slides from a presentation by Jamie McAndrews at a recent Bank of Canada conference. People who concern themselves with the economics of payments systems (and there should actually be many more of such people), including Jamie's group at the New York Fed, focus on issues to do with the timing of payments during a given day among financial institutions, the Fed's policies toward daylight overdrafts, and how these things relate to general monetary policy issues. If reserve balances are too scarce during the day, then financial institutions might delay payments they need to make, and a type of coordination failure arises. One could always make a payment by taking out a loan (a daylight overdraft) from the Fed, but that is costly as the Fed charges interest on daylight overdrafts, and there are also credit limits. Why? The Fed is worried about systemic risk. If the Fed extends too much daylight credit, there may be a danger of systemic default where the Fed ends up holding the bag.

But, as McAndrews and company point out in their paper, the large quantity of reserves that has existed in the financial system post-crisis appears to have speeded up clearing and settlement in the payments system, and reduced the quantity of daylight overdrafts. They don't come up with measure of the welfare benefits, but it seems there has to have been a dramatic reduction in payment delay costs.

Is this a serious argument, or just part of an attempt by the Fed to justify the existence of a very large quantity of reserves that now appears to be out there indefinitely? It's important to recognize that reserves held overnight, and daylight reserves are very different animals. Overnight reserves, which is what is measured in the above chart, just sit. They are not used in transactions. Currently, most of the reserves in existence during the day also sit, but some of them are used in clearing and settlement among financial institutions - a transactions role for reserves. If we wanted it, we could have a lot of reserves in daylight hours, and zero reserves overnight. There are different ways to do this: (i) The Fed could inject the outside money every day through daylight overdrafts. If there is some worry about default risk, the Fed could take collateral against the daylight overdrafts, as in other large-value payments systems in the world. (ii) The Fed could conduct an open market purchase each morning. (iii) The Fed could do a reverse-repo in the overnight market at the end of each day.

With regard to the last option, reverse repos have become a bigger deal recently. The Fed once proposed reverse repos (along with term deposits at the Fed) as a "reserve-draining" tool - part of an exit strategy. The second chart shows that the value of reverse repos on the Fed's balance sheet is currently about triple what it was before the financial crisis.

So, there seems a way to have our cake and eat it too. The Fed can have a small footprint, and also make reserves sufficiently plentiful during daylight hours to make large-value financial transactions occur efficiently.

The Fed and Forward Guidance

The news from the December 13 FOMC minutes is in the very last part, following the policy decision, and relates to "forward guidance," i.e. information that comes from the FOMC about the future path for policy instruments. Here's the relevant passage in the minutes:
After the Committee's vote, participants turned to a further consideration of ways in which the Committee might enhance the clarity and transparency of its public communications. The subcommittee on communications recommended an approach for incorporating information about participants' projections of appropriate future monetary policy into the Summary of Economic Projections (SEP), which the FOMC releases four times each year. In the SEP, participants' projections for economic growth, unemployment, and inflation are conditioned on their individual assessments of the path of monetary policy that is most likely to be consistent with the Federal Reserve's statutory mandate to promote maximum employment and price stability, but information about those assessments has not been included in the SEP.

A staff briefing described the details of the subcommittee's recommended approach and compared it with those taken by several other central banks. Most participants agreed that adding their projections of the target federal funds rate to the economic projections already provided in the SEP would help the public better understand the Committee's monetary policy decisions and the ways in which those decisions depend on members' assessments of economic and financial conditions. One participant suggested that the economic projections would be more understandable if they were based on a common interest rate path. Another suggested that it would be preferable to publish a consensus policy projection of the entire Committee. Some participants expressed concern that publishing information about participants' individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants' projections of the target federal funds rate as signaling the Committee's intention to follow a specific policy path rather than as indicating members' conditional projections for the federal funds rate given their expectations regarding future economic developments. Most participants viewed these concerns as manageable; several noted that participants would have opportunities to explain their projections and policy views in speeches and other forms of communication. Nonetheless, some participants did not see providing policy projections as a useful step at this time.

At the conclusion of their discussion, participants decided to incorporate information about their projections of appropriate monetary policy into the SEP beginning in January. Specifically, the SEP will include information about participants' projections of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP also will report participants' current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions. An accompanying narrative will describe the key factors underlying those assessments as well as qualitative information regarding participants' expectations for the Federal Reserve's balance sheet. A number of participants suggested further enhancements to the SEP; the Chairman asked the subcommittee to explore such enhancements over coming months.

Following up on the Committee's discussion of policy frameworks at its November meeting, the subcommittee on communications presented a draft statement of the Committee's longer-run goals and policy strategy. Participants generally agreed that issuing such a statement could be helpful in enhancing the transparency and accountability of monetary policy and in facilitating well-informed decisionmaking by households and businesses, and thus in enhancing the Committee's ability to promote the goals specified in its statutory mandate in the face of significant economic disturbances. However, a couple of participants expressed the concern that a statement that was sufficiently nuanced to capture the diversity of views on the Committee might not, in fact, enhance public understanding of the Committee's actions and intentions. Participants commented on the draft statement, and the Chairman encouraged the subcommittee to make adjustments to the draft and to present a revised version for the Committee's further consideration in January.
The FOMC statement has, since August 2011, contained this language:
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
The last few words are the forward guidance, i.e. barring some unforeseen dramatic events, the policy rate will not change until mid-2013. Given the failure of the recovery from the recession to proceed as quickly as anticipated, the Fed is under intense pressure from some quarters to do something more than what it has already done, which includes: (i) lowering the interest rate on reserves (now the key policy rate) to 0.25%, where it has been since October 2008; (ii) purchasing large quantities of mortgage-backed securities, agency securities, and long-term Treasury securities, resulting in a more-than-tripling in the size of the Fed's balance sheet. The idea behind forward guidance is that anticipated Fed policy actions are important for economic activity; if anything they are more important than what we actually see the Fed doing today. Such anticipated future monetary policy actions are critical for how consumers and businesses make decisions about borrowing and lending in credit markets, and those decisions are critical for the economic recovery.

Recall that the type of forward guidance in the current FOMC statement was the subject of some controversy in August 2011. Fisher, Kocherlakota, and Plosser dissented from the original FOMC decision, in part because they thought this was inappropriate forward guidance - essentially the wrong kind of commitment. Since August 2011, other FOMC members have apparently been thinking about other kinds of forward guidance, with Charles Evans being perhaps the most vociferous. He would apparently have liked to have seen specific language in the FOMC statement making future policy actions specifically contingent on the unemployment rate and the inflation rate.

What was actually adopted seems a compromise. The FOMC will now include information in its Summary of Economic Projections about the future Fed policy that actually goes into the forecasts. As I understand it, The Summary of Economic Projections represents some averaging across forecasts made by each regional Federal Reserve Bank and by the staff at the Board of Governors in Washington. When for example the Federal Reserve Bank of Boston staff do a forecast, part of the forecast has to be the future path for the Fed's policy rate, and perhaps the future paths of some items on the Fed's balance sheet, if those things are in the model the Boston Fed is using. I'm not sure how they do that, as I have never been in on one of these exercises. Maybe they simply fix a future path for the fed funds rate, and then make the forecast conditional on that. Maybe their model contains an estimated policy rule, and then part of the forecasting exercise involves tweaking that rule with add factors to produce a forecast that the forecasters feel comfortable with. For the Boston Fed, the latter would be the sensible procedure, one would think.

So, what we will now see, instead of this summary of economic projections is one that includes some averaging of forecasts for future Fed policy. What do you think this will communicate to us? For anyone who wants the information, and is willing to pay for it, Macroeconomic Advisers, for example, can probably forecast the behavior of the Fed as well as the Fed can forecast itself. So given that you care about these things, you already subscribe to Macro Advisers, and the extra information from the Fed has close to zero value. For the rest of the general public, the Summary of Economic Projections is almost certainly not on your radar screen. Maybe the information could be filtered through the media in a reasonable way, but the result might just be an increase in confusion. More information is not always better.

Addendum: I ran across this speech by Charles Plosser which perhaps makes clearer what the FOMC has in mind here. Plosser says:
The Summary of Economic Projections provides a better and more natural way to convey the Committee’s sense of the future path of policy. Currently, the SEP indicates individual policymakers’ forecasts of the key economic variables, including output, inflation, and unemployment conditional on each policymaker’s assessment of “appropriate policy” in the absence of further shocks. I think a more appropriate and meaningful way for the Committee to convey forward guidance would be to report information about Committee members’ underlying view of “appropriate policy.” This additional information would provide a useful picture of the range of views of future policy as envisioned by the policymakers. These views would not constitute a commitment to follow a particular path but would evolve as economic conditions changed. This information would add a useful signal to the markets as to the thinking of the Committee on an ongoing basis.
Plosser hopes that people will understand that the extra information included in the SEP is there just to reveal "the thinking of the Committee," and will not be interpreted as a solid commitment. People do get confused, though.