Crazy Like Foxes

Chris House's discussion of Tom Sargent's principles, and some of the related blog discussion, is closely related to what I said here. What I think House is getting at is the following. Self-described blogosphere "progressive" economists have a political agenda. They want particular changes in economic policy, and they try to use mainstream economics to support their policy conclusions. But House thinks this group is going overboard. His argument, as I see it, is that the case is being overstated, and that some people are being demonized in the process, who should not be. Overstating the case propagates ideas that will come back to bite us in the future - truth may hurt, but it can only help us in the long run. And the demonization of individuals who constructed key elements of what we do as economists cannot help the profession - this only leads to distrust of the economics profession by lay people.

I think that House, in his response to Paul Krugman, was overly gracious, to say the least. Here's what Krugman had to say. Krugman starts with this:

America, it goes without saying, has a powerful, crazy right wing. There’s nothing equivalent on the left — yes, there are individual crazy leftists, but nothing like the organized, lavishly financed madness on the right.

Is the far right wing of U.S. society "crazy?" Of course not. Out of respect for the mentally ill, we shouldn't fling words like "crazy" around lightly. The far right is quite rational, and they have well-defined goals. They want easy access to all manner of dangerous weapons; they do not want extended government participation in health care; etc. Is the far right powerful? Yes and no. They have indeed been successful in promoting lax gun control. But the United States now has in place an extended health care program with government participation. Democrats control the executive branch and the Senate, though the House is of course in control of the far right wing of the Republican party, and the left seems to be losing on the Supreme Court.

Krugman goes on to say this:

Which brings me to this critical piece by Chris House. A while back House declared that both Ed Prescott and yours truly say crazy things; when asked for an example of me saying something remotely equivalent to something like Prescott’s declaration that there is no evidence that Fed policy matters, he never did answer.

Now House takes me and Noah Smith to task for preaching to the left-wing echo chamber in what we wrote about the Tom Sargent speech that’s making the rounds. And once again I have to wonder whether he actually read what I wrote, or simply assumed that it must be over the top.

Why this produced such a polite reply from House is beyond me. Krugman is (groundlessly) accusing House of making claims without evidence, and stating things about Krugman's post without reading it. I read all this stuff myself, and I thought House was quite fair and careful. Here's some of what Krugman actually said in his two posts (here and here) concerning Tom Sargent's 2007 Berkeley graduation speech:

So why the sudden attention to Sargent’s 2007 speech? I think it’s fairly obvious: it’s essentially stealth anti-Keynesian propaganda, cloaked in the form of a widely respected and liked economist uttering what sound like eternal truths. But they aren’t, and the real goal here is to undermine the case for fighting unemployment in the here and now. There are virtues to that 2007 talk, but right now is no time for 2007 Sargent.

That paragraph actually is crazy - it reflects paranoia. As I explain here, Sargent's speech is a very terse set of innocuous, mainstream, economic ideas, that are entirely consistent with Krugman's thinking, Mike Woodford's thinking, Ed Prescott's thinking - whatever. Anti-Keynesian propaganda, untruths, conspiracy? Nonsense.

Now, back to Krugman's last missive on the matter. This casts "progressives," and particularly Krugman's blogosphere friends - DeLong, Thoma, Konczal, and Wren-Lewis - as poor downtrodden "voices in the wilderness" fighting against a set of powerful bullies. I have no objection to an organized fight against the forces that make firearms proliferate, and the promotion of broad-based health care in the United States, for example. What I object to are bad economic ideas, and the misrepresentation of sound academic work in economics. And I think that is part of what gets propagated by at least some members of what is being characterized as a "progressive" group here. I think Mark Thoma and Simon Wren-Lewis are honest and have good intentions, but Krugman and DeLong? Not so much.

In the final paragraph of this last post, Krugman states:

I won’t ever say anything I don’t believe to be true...

I don't have hard evidence for this, but I think that's a lie. Given Krugman's body of academic work, I do not believe he can honestly state that there are easy solutions to our economic problems that are at the fingertips of typical undergraduate students in economics 101. How could he think such a thing? There may be a few problems for which the answers are easy, but most of this is very difficult. To state otherwise doesn't help anyone.

Piketty and the Macroeconomists

I have not read a word of Thomas Piketty's Capital in the Twenty-First Century. As far as I can understand from secondhand and thirdhand accounts, it has something to do with outrage about the wealthy, measuring the rate of return on capital, and how we can tax those worthless wealthy bastards. The quotes and reviews on Amazon use words including "pioneering," "explosive," "seminal," "magisterial," etc. Some people want to petition the Pope to put Piketty in line for sainthood. This is pretty exciting. I think I should buy the book, and would be happy to contribute to Piketty's wealth. Hopefully he won't be successful in taxing himself back into poverty.

Tyler Cowen points out that there is a body of research studying wealth inequality, which apparently Piketty does not reference. This surprises me. After all, Paul Krugman (a very serious, straightforward, and trustworthy scholar, if there ever was one) points out that:

...if you think you’ve found an obvious hole, empirical or logical, in Piketty, you’re very probably wrong. He’s done his homework!

This bears investigating, I think.

Tom Sargent: What's Between the Lines

For some obscure reason, Tom's Sargent's Berkeley graduation address from seven years ago is now getting attention in the blogosphere. It's innocuous stuff - basically core ideas in economics boiled down to life lessons for graduating seniors. Paul Krugman seems a little insecure about it though (here and here) and would like you to dismiss parts of it as some sort of right-wing "cockroach" ideas. I can see what Krugman is getting at - he might see these ideas as threatening, as they are at odds with his notion that economic policy is easy, or that large welfare gains from changes in policy are low-handing fruit. But I think you have to be a rather suspicious person to think that Sargent's synopsis of economic ideas represents a particular view on policy. Indeed, the ideas are entirely consistent with how Mike Woodford, or Ed Prescott, thinks about the world.

So, let's go through Sargent's address, so you can see what I mean:

I remember how happy I felt when I graduated from Berkeley many years ago. But I thought the graduation speeches were long. I will economize on words. Economics is organized common sense. Here is a short list of valuable lessons that our beautiful subject teaches.

[I had to think about whether I agree with the "organized common sense" view of economics. If common sense is supposed to be what the average layperson possesses, then economics is not common sense, as it's sometimes (if not often) counterintuitive. For example, Adam Smith told us that greed can be a good thing. That's certainly not part of collective wisdom, I think. But Sargent was trying to put the Berkeley graduates at ease. He's telling them that doing economics is just a matter of putting pieces of straightforward logic together to come up with a coherent set of ideas.]

1. Many things that are desirable are not feasible.
[This is typically one of the first things taught in Econ 101. As a society, and as individuals, we face constraints. But what are society's constraints? That's what economists argue about. Some people think, for example, that the U.S. economy is no more constrained in what it can achieve in 2014 than it was in 2007. Those people think that the decision-makers in the Fed and the U.S. Congress, are somehow not optimizing given their constraints - they think there are more desirable outcomes that are in fact feasible. Others don't agree.]

2. Individuals and communities face trade-offs.
[This is again a key part of any Econ 101 course - opportunity cost. This is about the nature of the constraints we face. Individuals face budget constraints. One can't have a new car without giving up something else - other goods and services in the present, or future consumption. Economic growth models tell us that, as a society, to attain higher productive capacity in the future, we have to give up consumption in the present. But, at the societal level, again, economists have key arguments about what the tradeoffs are. In the 1960s, Solow and Samuelson argued that a Phillips curve tradeoff existed - the central bank could achieve lower unemployment, but only at the expense of higher inflation; Milton Friedman said that this was only a short-run tradeoff, and in the long run no such tradeoff exists; the Phillips curve went out of fashion; the Phillips curve was resurrected in the 1990s by New Keynesians; many macroeconomists are still skeptical.]

3. Other people have more information about their abilities, their efforts, and their preferences than you do.
[I'm glad Sargent included this idea, which is not part of the typical Econ 101 curriculum. But this is at the heart of many contemporary economic issues. Why are there banks, and what do they do? What were the incentive problems that led up to the global financial crisis? What's a financial crisis about anyway? How do we explain unemployment and the process of labor market search? For all of these issues we have to think carefully about private information and how it matters for the functioning of markets and economic institutions. A whole array of economic machinery developed over the last 50 years allows us to come to grips with these things.]

4. Everyone responds to incentives, including people you want to help. That is why social safety nets don’t always end up working as intended.
[This is closely related to #3. Take unemployment insurance (UI), for example. A key problem in designing a UI system is that there is moral hazard - it's hard for the government to observe how much effort the unemployed are putting into looking for a job, and the more generous is UI, the less effort is expended in searching. So, this represents another societal tradeoff. Providing better UI is good, as it provides insurance against a bad outcome - being unemployed. But the better insurance UI provides, the lower is the search effort of the unemployed, on average, and the higher will be the average unemployment rate. The latter is bad for society, as we lose output.]

5. There are tradeoffs between equality and efficiency.
[Closely related to #5. For example, redistribution of income through the income tax system (progressive taxation by which we tax the rich at a higher rate than the poor) can be seen as a form of social insurance. Being born poor is no fault of an individual, and may disadvantage him or her for life. Just like UI, progressive taxation acts to insure people against bad outcomes. But redistribution changes incentives. If I am born poor, the insurance provided by the government discourages me from investing in my own human capital - acquiring education and skills that allow me to do better. Similarly, those born rich are also discouraged. Why acquire high-level human capital if the return on that human capital is low because it is taxed at a high rate? Again, society faces a tradeoff - we can redistribute the pie, but that tends to make the pie smaller.]

6. In an equilibrium of a game or an economy, people are satisfied with their choices. That is why it is difficult for well meaning outsiders to change things for better or worse.
[Note here that Sargent doesn't say it's impossible to make things better - it's just difficult. Here's an example. A typical Econ 101 example of this principle at work is the minimum wage law. Workers and firms engage in private contracts. Firms offer jobs at particular wages - the people who are employed in those jobs have accepted those terms of employment. The firms and workers did the best they could under the circumstances. So why should we intervene in these private contracts, for example by imposing a floor on the wage a firm can offer a worker? Well, we might see this as social insurance, in which case we are back to #5. What's the tradeoff? Further, an issue that comes up here is that the tradeoff might be better if we use one mechanism to redistribute income rather than another. In this case, Econ 101 tells us that we're better off as a society if we redistribute using the tax system, or lump sum payments to the poor rather than by using the minimum wage. One problem with the minimum wage is that we're taxing the firms we're asking to provide employment for the poor.]

7. In the future, you too will respond to incentives. That is why there are some promises that you’d like to make but can’t. No one will believe those promises because they know that later it will not be in your interest to deliver. The lesson here is this: before you make a promise, think about whether you will want to keep it if and when your circumstances change. This is how you earn a reputation.
[Anyone who has had to deal with 2-year-olds - or has been the chair of an economics department - understands this perfectly. The people whose behavior you are trying to shape with your current promises have excellent memories and will punish you forever if you break those promises. This is the basis for limited commitment models in economics. Limited commitment - e.g. the "time consistency" problem - has been highly influential in policy debates, from Kydland and Prescott's watershed work on. Limited commitment is also key to credit relationships, and the use of collateral - again crucial for figuring out the financial crisis, and the role of policy in the crisis.]

8. Governments and voters respond to incentives too. That is why governments sometimes default on loans and other promises that they have made.
[Again, this is critical for thinking about current policy issues - sovereign debt problems for example. Commitment and incentives were at the heart of the Fed's rationale for its recent forward guidance experiments. In New Keynesian macro models, which formed the theoretical backdrop for the policy, promises about the future are important for attaining good results in the present, in contexts where conventional policy doesn't work. But when the future arrives, the policymaker will want to go back on the promise, so commitment to the policy is required. Of course, this is a bad example of commitment at work, as the Fed botched it.]

9. It is feasible for one generation to shift costs to subsequent ones. That is what national government debts and the U.S. social security system do (but not the social security system of Singapore).
[Most of what you need to know about this is in Peter Diamond's 1965 paper. This is one of the neatest tricks in economics. The world consists of overlapping generations of individuals. If we can get each young generation to give a gift to each old generation, then (under some conditions) we can make everyone better off - forever. So there are some circumstances where - indeed - we can get something for nothing. In practice, the gifts from young to old can be accomplished through a social security system, through government debt (as Diamond showed), or through monetary exchange (as Samuelson showed). Very cool.]

10. When a government spends, its citizens eventually pay, either today or tomorrow, either through explicit taxes or implicit ones like inflation.
[This is closely related to #1 and #2. Running a government requires real resources - workers, buildings, fuel, etc. Those resources don't come for free - there are tradeoffs. Some people - Krugman for example - would argue that there are circumstances in which more government spending is effectively free. The argument is that, if there are unemployed workers willing to work, then employing them makes them better off, and gives the rest of us more stuff to boot. In the story, there can even be a multiplier - a free lunch - by which one unit of government spending produces more than one unit of additional GDP. The odd thing about this is the disconnect between modern Keynesians and Old Keynesians on the issue. Multipliers somehow seem convincing - they satisfy the "common sense" test of the person on the street. But the standard multiplier mechanism is nowhere to be seen in a mainstream New Keynesian model. Further, in episodes like World War II with massive increases in government spending, it's clear what the resource costs are - a small drop in current private consumption, and a very large drop in private investment spending (future consumption).]

11. Most people want other people to pay for public goods and government transfers (especially transfers to themselves).
[You can see this in current debates over health care. Some senior citizens receiving medicare benefits see those benefits as some kind of birth right, but object to government programs that attempt to extend health insurance to the previously uninsured. There are some goods and services for which public provision is appropriate - national defense being the leading example. But it's impossible to provide an appropriate amount of public goods if we are going to finance their provision through voluntary contributions (as we do in NPR pledge drives). We have to collectively agree to government confiscation (tax collection) to make this work.]

12. Because market prices aggregate traders’ information, it is difficult to forecast stock prices and interest rates and exchange rates.
[This is just simple financial arbitrage - there are no free lunches available to your average financial market participant. Fama called this the "efficient markets hypothesis." But that's a misnomer, as by now we understand that perfect arbitrage in financial markets can occur in economies which are highly inefficient in the standard economic sense.]

So, Sargent has been pretty terse - that's the way he is. But these 12 ideas are very much mainstream. The ideas are consistent with economic inefficiency, a role for government, and provide a basis for analyzing how governments and central banks can make our lives better. I'm not sure what Paul Krugman is afraid of.

Deflation in Sweden: Svensson's Advice is the Problem, Not the Solution

As Lars Svensson notes, Sweden now has inflation that ranks among the lowest in the world. From the Riksbank's website, CPI inflation in Sweden looks like this:

The Riksbank has a 2% inflation target, so clearly they are missing on the low side. Of course, given the typical wishful thinking of central bankers, you can see from the chart that they are forecasting that they will hit the target a year from now, and exceed it later in 2015 and 2016.

So, why is inflation so low in Sweden? Svensson claims:

The deflation has been caused by the Riksbank’s tight monetary policy since the summer of 2010.

In Sweden, the Riksbank's policy rate is the repo rate, which is set by the Executive Committee of the central bank, and has followed this path since 2008 (again, from the Riksbank's web site):

So, does the repo rate path in the last chart represent a policy that was too tight, i.e. was the policy rate too high? How could we answer that question? Svensson might think about policy in terms of a Taylor rule, so it might help to look at the performance of the real side of the economy in Sweden. Here are real GDP growth rates (from the Riksbank's web site again):

For good measure, we should look at the real GDP levels too:

So, in the last two charts, you can see that the downturn in Sweden during the recession was larger, but the recovery was stronger than in the US, with Swedish real GDP returning to its pre-recession level earlier than in the U.S. But there has been lower growth in Sweden in 2012-13 so, relative to 2007Q4, the US and Sweden are in essentially the same place.

The Riksbank kept the policy rate at 0.25% well into 2010 and then, as the recovery proceeded at a normal pace and inflation increased, the policy rate went up, in typical Taylor-rule fashion. The policy rate reached a peak of 2% (not very high, right?) in late 2011, and then, as the Riksbank started to see real GDP growth below 3% and inflation below the 2% target, it quite promptly began cutting the policy rate. The policy rate is currently at 0.75%, and plans for its future path, conditional on the forecast, can be seen in the second chart. But what happens if the inflation rate stays low? From the Riksbank's last policy statement:

Monetary policy needs to remain highly expansionary to contribute to inflation rising towards the target. Although inflation has been somewhat lower than expected, only a minor revision has been made to the inflation forecast. The Executive Board of the Riksbank has therefore decided to hold the repo rate unchanged at 0.75 per cent. It is judged appropriate to begin gradually raising the repo rate in one year's time, when inflation has picked up.

As economic activity strengthens, inflationary pressures are expected to rise. However, it is uncertain how quickly inflation will rise, particularly as it has been weaker than expected for some time now. The repo-rate path has therefore been adjusted down somewhat and reflects a greater probability of a repo-rate cut in the near term compared with the assessment made in February.

That's from a section titled "Low Interest Rate Until Inflation Picks Up." Clearly, if inflation remains low, the policy rate will remain low.

So, it seems to me that the Riksbank has been, and is, playing pretty much by the Old-Keynesian/New Keynesian book. Why Svensson doesn't like what the Riksbank was and is doing is not apparent from the data. We need to dig deeper to find out why he's so critical. Svensson was a Deputy Governor of the Riksbank from May/2007 to May/2013. At a critical juncture in June 2010, the Executive Board of the Riksbank voted to increase the policy rate 1/4 point to 0.5%. Svensson dissented:

Deputy Governor Lars E.O. Svensson entered a reservation against the repo-rate path and advocated a repo-rate path with a repo rate of 0.25 per cent through the fourth quarter of 2010, and thereafter a gradual return to the repo-rate path of the main scenario. Lars E.O.Svensson maintained that such a repo-rate path results in a better outcome for both resource utilisation and inflation, with both lower unemployment and CPIF inflation closer to the target.

After leaving the Riksbank, in September 2013 Svensson wrote this post, in which he claims that, if the Riksbank had not only done what he had recommended in June 2010, but kept the policy rate at 0.25% until the current time, the inflation rate would be at the 2% target, and unemployment would be lower. In Svensson's September 2013 post, it is not clear to me what model he used to come up with his counterfactual, but suffice to say that, whatever the model is, it tells us that a short-term real interest rate of -1.75% can be sustained for 3 1/2 years, which seems goofy. One thing I would be interested in seeing is the output this model produces under the actual path for the policy rate. My guess is that it predicts inflation well above what actually occurred. Off the top of my head, I would say that, under Svensson's policy scenario, the inflation rate would currently be lower, and the unemployment rate would be about the same as what we're actually seeing in Sweden now.

Of course, this is just quibbling over history. What does Svensson think the Riksbank should do now if it wants to hit its 2% inflation target?

The most important thing is that the Riksbank takes the inflation target seriously and stops neglecting it. In order to get inflation back to target soon, the policy rate has to be lowered quickly to 0.25 percent or even zero. If this does not help, the Riksbank – as other central banks at the zero lower bound with too low inflation and too high unemployment – will have to use unconventional (but by now frequently tested) policy measures. These include a negative policy rate, large-scale asset purchase to lower long interest rates (quantitative easing), a low policy-rate path for a longer period with different variants of “forward guidance”, foreign-exchange interventions to depreciate the currency or at least (as in Switzerland) prevent it from becoming too strong, and to aim to overshoot the inflation target for a few years.

By now, it should be well known that Taylor rules have some very undesirable properties. In particular, a central bank which follows a Taylor rule blindly can get stuck in a policy trap, in which the policy rate is at the zero lower bound, and inflation is low or negative. The central bank wants higher inflation, and thinks it will achieve this by lowering the policy rate, which is not feasible, so the policy rate stays at the lower bound and - given that the Fisher relation holds in the long run - inflation stays low or negative. This is the policy trap that Svensson's advice would lead the Riksbank into.

Once the Riksbank is stuck at the zero lower bound, what would Svensson have it do? Unconventional policy is the prescription. As Svensson notes, unconventional policy has been "frequently tested." So how did that work out? In the U.S., as you know, the Fed has been deeply into unconventional policy for the last five years - quantitative easing (QE) and forward guidance in particular. But apparently those experiments have not been so successful, as the inflation rate has been falling for the last two years or more:

Another notable experiment is the Bank of Japan's "Quantitative and Qualitative Monetary Easing Program," which began in April 2013. Here's how that's going:

While there was a bit of a burst in inflation toward the end of 2013, the year-over-year inflation rate in Japan is now less than 1/2%.***

In Sweden, the Riksbank cannot consistently meet its inflation target of 2% if the policy rate stays low or goes to zero. The Fisher relation guarantees that. In order to meet its inflation target, the Riksbank has to increase the policy rate - there's no other way to do it.

In addition to the standard Taylor-rule policy-trap problem, there are two elements of Svensson's unconventional policy recommendations that further exacerbate the problem, in terms of how Svensson looks at it. First, if QE works in the long run the way I've modeled it, then it will ultimately produce less inflation, not more, if the policy rate stays low or at the zero lower bound. Second, consider Svensson's "negative policy rate" recommendation. This appears to be a variant of the idea that, if our problem is a binding constraint on the nominal interest rate at zero, then we should relax the constraint by somehow taxing the liabilities of the central bank. Miles Kimball loves this idea. Basically, the central bank could tax reserve accounts, and there are schemes that might allow taxation of currency or its electronic replacement.

What would be the effect of taxing central bank liabilities? For simplicity, think about a world with perfect certainty. In the long run, standard asset pricing gives us the Fisher relation, which is

R = r + i,

where R is the short-term nominal interest rate, r is the real interest rate, and i is the inflation rate. If central bank liabilities are not taxed, then arbitrage gives us the zero lower bound, i.e. R cannot fall below zero. But if we tax central bank liabilities at the rate t per period, then the lower bound on R is -t. Therefore, in the long run, if R is targeted at its lower bound by the central bank,

i = - r - t

So, if we think that r is invariant to monetary policy in the long run, then if the central bank pegs the nominal interest rate at its lower bound, and central bank liabilities are taxed, this will make long-run inflation lower.

Basically, people who advocate for taxes on central bank liabilities as a means for increasing inflation are making the same error as are people who are concerned that the currently large stock of reserve balances in the United States might ultimately produce more inflation (a group of people that may or may not have once included yours truly). For example, you might think that, if you tax central bank liabilities, then people have less inducement to hold those liabilities, and inflation results due to some kind of hot-potato effect. Similarly, you might think that, as assets other than money become more attractive (as the economy recovers and real returns rise), that inflation might rise, for a similar reason. Well, that logic is wrong. To induce people to hold central bank liabilities when the nominal interest rate has been at its lower bound for a long period of time, the inflation rate must be sufficiently low, so that the real return on money is sufficiently high. If we tax central bank liabilities, or the real returns on alternative assets are higher, the inflation rate must be all the lower in the long term, in order to make central bank liabilities sufficiently attractive that people will hold them.

***Addendum: I made an error in the chart by including a March observation which was a preliminary estimate for something that was not in fact the national CPI. Here's the chart that (correctly) drops the last observation:

So that doesn't give the dramatic story I thought it did, i.e. year-over-year inflation is still up around 1.5%, though short of the Bank of Japan's 2% inflation target. Note as well, that if we look at the levels, in January the CPI fell, and there was no change in February.

Further, if we take a longer view:

So, in spite of the recent blip in inflation, the average rate of inflation in Japan over the last twenty years is about zero, and in that 20-year period we have seen other short bursts of inflation. Thus, the Bank of Japan seems to have had some difficulty in producing inflation - but this time may be different. Given that the Bank seems intent on holding the short-term nominal interest rate at zero (essentially), I don't see it, but I'm curious to see how the data unfolds.

The FRB/US Model and Inflation

The Board of Governors has posted details on the structure of the FRB/US model, the data used in estimating the model, published work using the model, etc. If you have access to EViews, it appears you can also run simulations. There is even a long disclaimer, presumably to cover cases where someone takes the model too seriously, uses it for retirement planning or some such, and then wants to sue the Fed. On this, I have a proposal, which is a blanket disclaimer to cover everything - public speaking by Fed employees, casual chit-chat in the coffee shop, whatever:

Please don't ever pay close attention to what we say, or take any action based on such utterances. We're only joking most of the time anyway. If you really think we're saying something important, you're not as smart as you look.

That should do it, I think. The Fed can state this once, and then never say it again.

The FRB/US model, used by the Board for forecasting and policy analysis, is the culmination of perhaps 45 years of work. Various generations of management at the Board have directed some smart people to work on this thing, and you can feel the weight of the large quantity of quality-adjusted hours of work that went into putting it together. But is it any good? Could the Board do just as well or better at forecasting with a much simpler tool? Could a well-educated and well-informed economist do a respectable job of central banking without ever looking at the output of the FRB/US model?

Long ago in a galaxy far far away, large-scale macroeconometric models were taken very seriously. This 1959 paper by Adelman and Adelman was published in Econometrica. They simulated the Klein Goldberger model on an IBM 650, which was the first mass-produced computer. Here's what that looked like (from Wikipedia):

The Klein-Goldberger model was small relative to the FRB/US model - 15 equations. It was first estimated in 1955 using electro-mechanical desk calculators. In those days running a regression was a big job - you will understand the magnitude of the task if you have ever had to invert a matrix by hand. By the late 1960s, the Klein-Goldberger model had evolved into the large-scale FRB/MIT/Penn model, which is a distant ancestor of the FRB/US model.

But shortly after large-scale models had been warmly embraced by policymakers in central banks and governments, they were trashed by the upstarts of the macroeconomics profession. I think the modern notion of the Lucas critique is that it calls into question "reduced-form" economics, "implicit theorizing," and such. But Lucas's paper actually had a more narrow focus. Lucas was criticizing large scale macroeconometric models. This is the key quote from his paper:

The thesis of this essay is that it is the econometric tradition, or more precisely, the "theory of economic policy" based on this tradition, which is in need of major revision. More particularly, I shall argue that the features which lead to success in short-term forecasting are unrelated to quantitative policy evaluation, that the major econometric models are (well) designed to perform the former task only, and that simulations using these models can, in principle, provide no useful information as to the actual consequences of alternative economic policies. These contentions will be based not on deviations between estimated and "true" structure prior to a policy change but on the deviations between the prior "true" structure and the "true" structure prevailing afterwards.

Clearly, this was not taken to heart at the Board, as the FRB/US model - in spite of some claims to the contrary - does not look so different from early macroeconometric models. Indeed, if Klein and Goldberger were alive, I don't they would find the FRB/US model an unfamiliar object, though the documentation is dressed up in the language of modern macroeconomics as practiced in most central banks. So, was Lucas wrong, or what?

There's a lot going on the the FRB/US model, but suppose we focus on something the Fed cares about, and is instructed to care about: the inflation rate. Inflation determination appears to be in a New Keynesian spirit. So, one thing that has changed from 1970s-era large scale macroeconometric models is that the money demand function has disappeared, and monetary quantities appear to be nonexistent. Inflation is determined - roughly - by an output gap and trend inflation, which is a survey measure of the ten-year-ahead inflation rate. For example, if a shock occurs in the model which causes a positive output gap, then inflation rises, and over time inflation will revert to the long run trend, which is exogenous.

So, this is purely Phillips-curve inflation determination, which certainly does not square with how I think about the inflation process. Neither does it square with the data, which is notoriously at odds with the view that output gaps are important in explaining or forecasting inflation, or the view that Phillips curves are stable. The Phillips curve does particularly badly over the past couple of years or so. Here is the output gap measure used in the FRB/US model:

So, given that, the FRB/US model tells us that inflation should have been rising recently. But headline pce inflation and core pce inflation have been falling:

If you look at Flint Brayton's memo on "A New FRB/US Price-Wage Sector," in the FRB/US documentation, you can get some idea of how the Board staff think about this. Staff members of course monitor how the model is predicting out of sample, but the model had not been doing well:

Inflation in the recent recession and its aftermath did not decline nearly as much as the 1985-2007 estimates would have predicted, a result that is common to many models of inflation.

So, apparently they found that the Phillips curve they had estimated was not stable - during the recession it was making inflation forecasting errors on the low side. The solution was to re-estimate:

ML estimation over a longer sample period that ends in 2012 reduces the sector’s unemployment slope coefficient by more than half.

ML is maximum likelihood. So, if the sample is extended to 2012, the Phillips curve starts to go away - the slope coefficient gets much smaller. But the Board staff doesn't seem to like this:

An alternative and more cautious re-assessment of the unemployment slope is obtained with Bayesian methods. Using the 1985-2007 ML parameter estimates and their standard errors as a prior, Bayesian estimation over the longer sample reduces the slope coefficient by one-third.

So, apparently being "cautious" is when you ignore the data and go with your intuition.

This is important, as it tells us something about how the Governors and the FOMC chair think about monetary policy decisions. The FRB/US model seems to be producing the Board's forecast and some policy scenarios that are used as input at FOMC meetings. And we know that Janet Yellen takes FRB/US quite seriously. The FOMC is predicting that the inflation rate will rise over time to 2%, and Janet Yellen has told us that she thinks that, under that scenario, the Fed's policy interest rate should start rising in spring 2015. Some people want to interpret that as a hawkish statement, but I don't think so, because I think the forecast - and FRB/US - is wrong. The FOMC has also stated that the policy rate will stay low if inflation continues to be low or falls, and I think that is the likely outcome, for reasons I have discussed before. So, given what the FOMC has told us about its policy rule, my prediction is that the policy rate will be where it is for considerably longer than Janet Yellen thinks it will.