Can we inject uncertainty into monetary policy?

May 21, 2009

Just had an interesting lunch with Nick Denton, who clarified that his 27% rise in revenues was year-on-year in the first quarter, and that the second-quarter rise in sales is even larger. He also talked about his decision to cut back in the face of a coming recession: while he has pangs of regret about selling Consumerist, he said, he also feels that recessions can be helpful when it comes to forcing business owners such as himself to take tough decisions they otherwise might be able to avoid taking.

Denton has a theory about how we ended up in the midst of this huge economic crisis: he blames the hubris of central bankers in general and Alan Greenspan in particular — people who thought they had abolished the business cycle, and whose belief was shared by the business and finance worlds. It’s the theory of the Greenspan put, basically — we all reckoned that if things got really bad then the Fed would bail us all out, as they did in 1991-2 and then again in 2000-1. As a result people weren’t nearly as cautious as they might otherwise have been inclined to be, and dangers built up until they exploded.

How to fix this? Is it not the job of the Fed to try to minimize the severity of recessions? One alternative approach would be to consider it to be the job of the Fed to minimize the severity of the worst possible recession. What would happen if, for instance, rates were set using a random-number generator? Every FOMC meeting, some kind of virtual die would be rolled, moving rates up or down even if that was the opposite of “correct” monetary policy. The resulting uncertainty would force people to take a more defensive stance at all times, just in case rates went sharply upwards — even if the probability of such a rate hike was quite low.

Maybe monetary policy is a bit like optimal poker strategy: a certain percentage likelihood that you’ll do this, a certain percentage likelihood that you’ll do that. The Fed governors can then release a decision saying, essentially, “we plugged in a 10% chance of a 50bp cut, a 50% chance of a 25bp cut, a 25% chance of keeping rates steady, and a 15% chance of a 25bp raise, and rolled the electronic dice; guess what, we we ended up with the 25bp raise”.

OK, so that’s probably a silly idea. But some element of uncertainty is I think useful in monetary policy.


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