Interview with Jon Steinsson: the economy is like a rumbling volcano

Jeff Horwich acts as an interlocutor “Interview with Jon Steinsson: Forward-looking guidance, the state of macroeconomics and how the economy is like a rumbling volcano” (Federal Reserve Bank of Minneapolis, December 19, 2022). There are many interesting comments on how to do empirical work with causation in macroeconomics, whether the Fed’s announcements affect the markets because of the policy change itself or because the policy change reveals the underlying the Fed’s view of the economy. why inflation expectations seem so sticky at the moment, whether members of the Fed’s Board of Governors should make public appearances more or less, and other questions. Here are a couple of comments that caught my attention:

The fundamental problem of limited data in the study of macroeconomics

We economists are often criticized for our inability to predict how things will turn out. I think people are not fully aware of the fact that we are trying to predict something, which is not only quite difficult, but we have seen very few cases of what we are trying to predict. In the United States in the post-war period, we have seen a dozen recessions. We have seen inflation actually triple or quadruple. It’s a bit like a weather forecaster trying to predict the weather but only seeing 12 storms.

Of course, I’m overdoing it a bit; There are many countries and we can learn from other countries. But the countries are interconnected. And the total number of events in terms of recessions and rising inflation that we have seen may be in the order of several hundred. This is a fairly modest amount of data that we use to draw conclusions about something extremely complex. And recessions are patchy: the COVID recession is very different from the Great Recession, which is very different from the Volcker recession.

Something similar is happening in Iceland right now, because there’s this volcano that’s rumbling there, which has erupted twice in the past two years. But this volcano has not erupted for 800 years. Volcanologists are asked every day on television to predict when the next eruption will occur, how long it will last, whether it will intensify or diminish.

I felt it was very much like us economists being asked the same questions about events that only happen once every ten years or so. I think the public understands the volcanologist more than the economist in this regard! I wanted to make this distinction because I think it’s important that people understand that the amount of data we have to operate on is very limited, and this plays a role in why we can’t predict everything perfectly.

Why the Fed’s Decisions Will and Should Surprise Markets

Meetings [of the Federal Open Market Committee] only happen every six weeks or so. And in the intervals between these meetings, all kinds of announcements and new data come. And for each of them, the market needs to think about how it thinks the Fed will react to this new data.

If we lived in a world where the Fed’s “reaction function” – how it reacts to new information – was fully known to everyone, then there would never be a mismatch between what the market thinks thinks the Fed, and what the Fed in fact thinks. But we don’t live in that world. I would be surprised if the members of the FOMC could even mentally articulate their response function. It’s too hard to do.

Disagreements between the market and the Fed will deepen over these six weeks. At the next meeting, the Fed will want to tell the market again, “Actually, this is what we think, this is how we view the data coming in for the last six weeks, and this is what we think we’re going to do going forward.”

It is inevitable that the Fed is going to surprise the market, and it must be ready to surprise the market. Otherwise, it puts the market in the driver’s seat of monetary policy, which doesn’t really make any sense even conceptually, because it’s a vicious circle, but certainly not a good policy. In that sense, I think it’s important that the Fed not be afraid to surprise the market.