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Don't Be a Macro Journalist

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June 27, 2012 – Comments (0)

Board: Deranged Monkey Criticism

Author: howardroark

When I was younger, I used to feel pretty smug watching baseball games. It was before Moneyball, but Bill James was already around. And he was such a talented writer that he could convince normalish 10-year olds that they understood very deep things about the world that eluded most others -- or even that they somehow discovered these things by themselves. So listening to announcers fill air time with popularized hogwash ("you have to bunt in this situation," "this team can't win without more speed") seemed like a constant affirmation of the scales that lay over most everyone else's eyes. And Bill James was mostly right. Don't bunt.

But then you get older. And you can't help but notice how many of the things that come out of your mouth when forced to speak extemporaneously are notably idiotic. Not quite the same as sitting alone in your bedroom with a disturbingly effeminate baby blanket and a copy of Baseball Abstract. Require me to fill three hours of largely dead time 162 times a year, and I will eventually claim that Jacob was the more talented Dylan. Now switch from checkers (sabermetrics) to 3D chess (macroeconomics). Suddenly, 'notably idiotic' is pretty much your best case. I try to remember that when I read most of the limited space WSJ and NYT articles and opeds (the FT is better) or especially watch CNBC after the Fed announces something like the extension of Operation Twist. Well, I actually have not matured much at all in the spontaneous smugness department, so I mainly scold myself later.

Think about how hard this job is. Operation Twist is what? It is the Central Bank rearranging the maturity structure of Treasury Debt. What effect does this have on the economy? What do stock and bond market reactions (your main talking point if you are on CNBC at 12:31pm) tell you about how this move is affecting the private sector? Here is the decision tree that you have to go through if you want to be a Macro Bill James and not a Ken Harrelson.

(1) What is already priced into the asset markets? Markets are forward looking, of course. But unlike Fed Fund futures, there is no explicit market for Operation Twist futures. Even if there were, it is not at all clear that you could capture the entire effect of the announcement relative to expectations, since the announcement is almost always about more than just a decision and a dollar amount. That's why if you go through the old Fed transcripts, they spend a large chunk of time sounding like a Sterling, Cooper creative meeting ("I don't like the use of the word 'but' there" -- actual instance). Did stocks go down because Operation Twist is considered a bad thing, or did they go down because expectations were for some kind of turbocharged Operation Twist or the like, and so it was really not enough of a good thing?

(2) Set aside the complication of what Twisty expectations were priced in for a minute. Even if we understood the direction in which markets were surprised, how does the surprise actually work? One possibility is that it creates something called a portfolio rebalancing effect. The idea is that by replacing longer term treasuries, which have more term premium and duration risk, with shorter term treasuries, the public will adjust its now lower risk portfolios into other assets. Those assets are likely to be riskier (to achieve the same risk as they had before), which means they are likely not to be money or near substitutes for money. This could then raise asset prices, bringing Tobin's Q effects and perhaps wealth effects, and lower interest rates on government debt -- all raising Aggregate Demand.

(3) But note that it is not at all guaranteed that this will or even should happen. An argument can be made, and has been made, that an operation like Twist or QE actually increases private sector risk. That is because longer term government bonds are actually the least risky asset in private portfolios right now, because they have negative beta (they go up the most when things go worst). This would essentially mean that such a move could create the exact opposite portfolio rebalancing effect: Private agents expect a decline in the amount of countercyclical assets available so they trade out of risk into safety, depressing AD.

(4) But of course both of these effects might be rendered entirely moot by a version of Modigliani-Miller irrelevance. In short, by merely shifting assets back onto its own balance sheet, the government is simply transferring risk (either high or low depending on whether you believer (2) or (3)) from the assets directly held by the public to the part of the public's portfolio represented by remaining government liabilities and tax obligations, so the public essentially has the same portfolio as before on a look through basis. Even if this doesn't work perfectly, it might be an important mitigating factor in whether this kind of thing has any effect at all.

(5) If you find that annoying already, it is not even the tip of the iceberg; you then have to deal with the second most undersold tenet in Macro journalism: Joint determination: All prices in an economy "happen" simultaneously in the sense that they affect each other. The so called transmission mechanisms like portfolio rebalancing or Tobin's Q can be thought of as really just stories to help us visualize that jointly determined process. What should happen if the traditional portfolio effect is in principle accurate (operation twist works to increase AD all else equal) and is also a surprise? At first it seems like stocks should rise and bonds should rise. But wait. If stocks rise because AD is expected to increase (this of course assumes there is some nominal problem that can be improved with a better equilibrium), then you might imagine people would expect higher inflation, and also probably higher real interest rates. So you could actually see bonds decline (higher yields discount higher expected rates), even though the entire mechanism is supposedly working by raising bond prices -- the trick is that bond prices are only rising relative to where they would otherwise be -- not actually.

(6) And then there is the number one undersold tenet in macro journalism: expectations matter a lot. Because there is this: Fed policy is not just about the hydraulics of what the Fed is currently doing (portfolio shifts), it is about what its thoughts and actions convey about its reaction function: What it (and the rest of the government) might do in the future given various economic scenarios. Expectations about the Fed's reaction function aren't separate from hydraulic effects like portfolio rebalancing. They interact. Even if portfolio balancing worked in principle, it might be that the Fed's statement also conveyed pessimism (meaning more tightness than expected) about future policy. Maybe the statement leads people to believe that the Fed would require more economic distress than previously assumed before implementing even more unconventional policies. It isn't really right to say that this might override other channels like portfolio rebalancing. Rather, it makes more sense to say the more direct communicative effect on expectations and the aforementioned mechanical channels all become bound up in wherever expectations (and thus behavior) end up. In other words, they are jointly determined.

And this is before even talking about whether in the current state of the world nominal variables can have positive real effects, or whether the Fed even has sufficient power to credibly change nominal expectations given its current operational limitations (no helicopter drops, no purchasing shares of BODY), or whether the Fed or the Treasury will end up "acting last" in determining the structure and duration of outstanding Treasury debt. The result of this incredible complexity is that a large percentage of the media and especially investment pundit discussions of monetary policy and macro either are or sound a lot like the same empty and under-thought filler of 1980s day-night doubleheaders. But in both cases, and especially this one, it's probably because the job is nearly impossible.

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