Known Unknowns


Welcome to Known Unknowns, a newsletter about what we don’t know.

Big changes at the Fed

In these dark, confusing, and complex times, we all find ourselves thinking back to simpler days when the world actually made sense. For me, that was when I was in college. I had a professor in grad school who said that you never know as much about the macroeconomy as you do as an undergrad. And that’s certainly true. You learn these simple models in which the Fed pulls a lever, in the form of something called interest rates, and then all this magic happens, and you believe it’s true in the real world, too.

Then you go to grad school, and you pick apart all of the assumptions behind what you’d learned before. You find how little we actually know about the transmission mechanisms of interest rate policy, especially when you use a model that assumes that financial markets are a mysterious but well-behaved black box where all the magic happens. You find out that there are term premiums and all of these higher order effects that undermine everything. And then you learn that the best the Fed can do is play mind games with markets—but that doesn’t work, either, because people in that black box are clever, too. Then all the Fed can do is set clear, humble expectations. Or, as that same macro professor said, the Fed can cause a recession if it jacks up interest rates (and this was the early 2000s, so he meant a lot—not the 25 basis point increases that we get now). But we’re not sure it can do much else.

Maybe that’s why I greeted the big announcement last week that the Fed will target average inflation with a big shrug. It was news to me that it could achieve 2%, anyhow. I agree that there have been structural changes that warrant rethinking some aspects of monetary policy. Natural interest rates are lower, which has serious implications for financial markets, and inflation may be driven less by monetary forces, which is pretty remarkable. I still believe in the Philips curve, but I think that’s because I believe that structural unemployment rates change over time, all of which means that the Fed has less control over the economy than it used to, even as it still does some pretty extraordinary things. I guess the latest announcement is really just a way of saying that interest rates will be really low for a really long time, even if we do have some inflation.

One concern that was raised when the Fed undertook extraordinary policies during the financial crisis was it would erode independence. Monetary policy also became the only game in town, since fiscal policy became both more difficult and more fraught. This created a world where the Fed is seen as all-powerful over the economy, and that belief can’t co-exist with independence. For example, take the increasingly popular idea that the Fed needs to target the Black unemployment rate.

The fact that Black Americans face higher unemployment than white Americans is a huge problem. However, its causes—education, job access, discrimination—are all structural. Interest rate policy will not do much to solve structural problems. The only argument that I’ve heard for how this will work is that if you keep interest rates very low, for a very long time, eventually employers will face overwhelming demand in a tight labor market and will get so desperate that they’ll overcome their discrimination.

Which is, well, an argument. But it’s not one consistent with anything that I know about monetary policy from grad school. It’s still an argument, though. And while inflation and employment are the Fed’s mandates, and the belief that low rates have no downsides has become an article of faith among the chattering classes, Fed also needs to worry about financial stability. Prolonged low rates mean less stability, which is also bad for Black Americans. Maybe interest rates have a 3rd order effect on Black unemployment, but there are huge first order costs to everyone—especially Black Americans.

This whole idea is a sad sign of our times. This is a time when we pass all economic issues off on the Fed, even if it doesn’t have the tools to handle it, and so we diminish the entire institution in the process. And we talk and point fingers, but we’re unwilling to do the difficult things that will actually help Black Americans, like provide better access to communities with good jobs, better education, and the like.

The other public health failure

I’ve noticed that people are really bad at living with risk. We always live with risk, of course, but when people become aware of a new source of risk, they really can’t handle it. Take the comments in this uncontroversial op-ed which says that you have to figure out your risk tolerance and learn how to live in the world of Covid. Commenters argue—and I’ve heard this a lot—“No! We can’t make this decision for ourselves, especially since it impacts others. The government must manage this risk for me, until a vaccine comes along one day to take this risk away once and for all.”

I think we’ve failed people, and it’s no wonder that lots of people feel this way. Risk communication is as vital to public health as mask-wearing, and communication has been as bad as it can be. There is evidence that people can make good decisions under conditions of uncertainty, but we need to communicate to people in ways that they find meaningful. Right now, though, we’re doing the opposite. I wrote something about how we can do better with Jessica Hullman, a professor at Northwestern and an expert on risk communication.

But even if people understand risk, can we actually trust them? Especially if their decisions pose harm to others, which is certainly the case with a highly contagious disease? Their risk preferences aren’t our risk preferences, and yet their choices impact others. We love to shame young people for what seems like reckless choices, but they do face a low risk of death (serious complications aren't as well understood yet). Their actions pose serious harm to others, but asking them to delay their lives for up to two years is a major sacrifice. And their lives are even more delayed, since they don’t yet have their own families and are just starting their careers. Their earnings may actually never recover. we need to think more strategically about protecting vulnerable people and asking less of young people, who may be more rational than we want to admit.

Until next time, Pension Geeks!