Friday, June 17, 2016

The St. Louis Fed's Regime-Based Approach

St. Louis Federal Reserve President James Bullard today presented “The St. Louis Fed’s New Characterization of the Outlook for the U.S. Economy.” This is a change in how the St. Louis Fed thinks about medium- and longer-term macroeconomic outcomes and makes recommendations for the policy path.
“The hallmark of the new narrative is to think of medium- and longer-term macroeconomic outcomes in terms of regimes. The concept of a single, long-run steady state to which the economy is converging is abandoned, and is replaced by a set of possible regimes that the economy may visit. Regimes are generally viewed as persistent, and optimal monetary policy is viewed as regime dependent. Switches between regimes are viewed as not forecastable.”
Bullard describes three “fundamentals” that characterize which regime the economy is in: productivity growth (high or low), the real return on short-term government debt (high or low), and state of the business cycle (recession or not). We are currently in a low-productivity growth, low rate, no-recession regime. The St. Louis Fed’s forecasts for the next 2.5 years are made with the assumption that we will stay in such a regime over the forecast horizon. They forecast real output growth of 2%, 4.7% unemployment, and 2% trimmed-mean PCE inflation.

As an example of why using this regime-based forecasting approach matters, imagine that the economy is in a low productivity growth regime in which the long-run growth rate is 2%, and that under a high productivity growth regime, the long-run growth rate would be 4%. Suppose you are trying to forecast the growth rate a year from now. One approach would be to come up with an estimate of the probability P that the economy will have switched to the high productivity regime, then estimate a growth rate of G1=(1-P)*2%+P*4%. An alternative is to assume that the economy will stay in its current regime, in which case your estimate is G2=2%<G1, and the chance that the economy switches regime is an “upside risk” to your forecast. This second approach is more like what the St. Louis Fed is doing. Think of it as taking the mode instead of the expected value (mean) of the probability distribution over future growth. They are making their forecasts based on the most likely outcome, not the weighted average of the different outcomes. 

Bullard claims that P is quite small, i.e. regimes are persistent, and that regime changes are unforecastable. He therefore argues that "the best that we can do today is to forecast that the current regime will persist and set policy appropriately for this regime."  The policy takeaway is that “In light of this new approach and the associated forecast, the appropriate regime-dependent policy rate path is 63 basis points over the forecast horizon.”

The approach of forecasting that the current regime will persist and setting policy appropriately for the current regime is an interesting contrast to the "robust control" literature. As Richard Dennis summarizes, "rather than focusing on the 'most likely' outcome or on the average outcome, robust control argues that policymakers should focus on and defend against the worst-case outcome." He adds:
"In an interesting application of robust control methods, Sargent (1999) studies a simple macro-policy model and shows that robustness, in the “robust control” sense, does not necessarily lead to policy attenuation. Instead, the robust policy rule may respond more aggressively to shocks. The intuition for this result is that, by pursuing a more aggressive policy, the central bank can prevent the economy from encountering situations where model misspecification might be especially damaging."
 In Bullard's Figure 1 (below), we see the baseline forecast corresponding to continuation in the no recession, low real rate of return, low productivity growth regime. We also see some of the upside risks to the policy rate path, corresponding to switches to high real rate of return and/or high productivity growth regimes. We also see the arrow pointing to recession, but the four possible outcomes associated with that switch are omitted from the diagram. Bullard writes that "We are currently in a no recession state, but it is possible that we could switch to a recession state. If such a switch occurred, all variables would be affected but most notably, the unemployment rate would rise substantially. Again, the possibility of such a switch does not enter directly into the forecast because we have no reason to forecast a recession given the data available today. The possibility of recession is instead a risk to the forecast."

 In a robust-control inspired approach, the possibility of switching into a recession state (and hitting the zero lower bound again) would get weighted pretty heavily in determination of the policy path, because even if it is unlikely, it would be really bad. What would that look like? This gets a little tricky because the "fundamentals" characterizing these regimes are not all fundamental in the sense of being exogenous to monetary policy. In particular, whether and when the economy enters another recession depends on the path of the policy rate. So too, indirectly, does the real rate of return on short-term government debt, both through liquidity premia and through expected inflation if we get back to the ZLB.