Get a Model, Make a Guess, Cure Unemployment: Caroline Baum
Just when you thought you’d heard the last of “jobs created or saved,” the Obama administration’s quarterly report card on its $814 billion fiscal stimulus, along comes the Federal Reserve with its own model-derived guesstimates.
The Fed’s full menu of securities purchases, starting with $1.7 trillion of Treasuries, agency and mortgage-backed bonds in late 2008 and 2009 and including the current $600 billion of intermediate- and long-term Treasuries, “will have raised private payroll employment by about 3 million jobs,” said Fed Vice Chairman Janet Yellen.
You’d think unemployed and underemployed workers would be ecstatic. Instead, 46.8 percent of consumers surveyed by the Conference Board said jobs were “hard to get” in December, down slightly from the peak reading of 49.4 percent in 2009.
With fiscal policy saving or creating 3.5 million jobs and monetary policy manufacturing another 3 million, why, the U.S. could be at full employment in no time!
The economy lost 8.5 million private-sector jobs from December 2007 to December 2009, recouping 1.3 million since then, according to the Bureau of Labor Statistics.
Yellen’s projections, presented at the Allied Social Science Association’s annual meeting in Denver last weekend, are based on simulations performed by the Fed’s macroeconomic model, known as FRB/US, not real jobs.
Error Bands
That would be the same model that failed to grasp that mortgage loans made during a period of exceptionally low interest rates by lenders with no skin in the game might not be repaid, putting major financial institutions on the brink of insolvency; the same model that failed to understand how new and exotic derivatives based on these mortgages would perform; the same model that failed to see the millions of jobs that would be lost if housing and credit bubbles were allowed to inflate until they burst; and the same model that predicted an unemployment rate of 8.8 percent in the fourth quarter of 2010 without the enactment of a fiscal stimulus. (It was 9.6 percent with it.)
Why do policy makers persist in perpetrating this fantasy, in asserting something that can’t be proven? Any econometrician will tell you “the error bands are huge and consistent with almost any result one might imagine,” said Bob Eisenbeis, chief monetary economist at Cumberland Advisors, in a Jan. 11 commentary on Yellen’s speech.
Confidence Game
For example, using a long series of historical data ending in 2010, FRB/US projects with a 95 percent confidence level the following conditions for the fourth quarter of 2012: a federal funds rate of 0.2 percent to 9 percent; an inflation rate of 0.4 percent to 4.2 percent; an output gap (the difference between actual and potential growth) of -5.3 percent to 5 percent; and an unemployment rate of 2.1 percent to 8.1 percent.
What does that do for your level of confidence?
Econometric models project the future on the basis of statistical relationships from the past. That’s why they stink in the case of those once-in-a-hundred-year floods, even if they are occurring more frequently. They don’t do well with shocks either, which is why they generally miss turning points.
In other words, if the current situation doesn’t line up with history -- what statisticians call an out-of-sample forecast -- the model generates errors.
If Yellen’s job-creation claims can be attributed to her undue reliance on models, what are we to make of her assertions that QE2 succeeded in lowering long-term interest rates, its stated objective?
Just the Facts
The yield on the 10-year Treasury note fell from 4 percent in April to about 2.4 percent in October as those green-shoot sightings proved to be hallucinations. Fed chief Ben Bernanke started hinting at another round of asset purchases in late August, but by then the big gains had already been made.
Ten-year yields at 3.4 percent today are well above their August levels.
“Market rates might well have backed up significantly following the November FOMC meeting if the committee had decided not to move ahead with the program,” Yellen said in her speech.
Governor Yellen, market rates did back up significantly following the November meeting of the Federal Open Market Committee even though it decided to move ahead with the program. That’s a factual to your counterfactual.
Another problem with the models favored by the Federal Reserve Board staff is that they are “Phillips-Curve type models that typically don’t have the financial sector playing a significant role,” said Eisenbeis, a former research director at the Atlanta Fed. “In those models, inflation is a real-side phenomenon driven mainly by resource utilization. There is no room in these models for money or Milton Friedman.”
Over the years, economists have become increasingly dependent on mathematical models that seem to exist for their own sake rather than to address real-world problems. If the Fed is interested in communicating clearly with the public, policy makers should start by speaking a language the rest of us can understand and leave fantasy forecasts to the elves.
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