Financial and Economic Literacy: Implications for a Fed policy rule

FINRA and a multitude of other online sources allow members of the public to test their financial literacy. Sadly, the results of these online quizzes showcase a lack of knowledge on basic financial matters by the public at-large. On FINRA’s version, the national average score is solely 2.88 correct answers out of the following 5 questions:

• Suppose you have $100 in a savings account earning 2 percent interest a year. After five years, how much would you have? (Answer choices are simply: “More than $102”, “Exactly $102”, “Less than $102”, and “Don’t Know”)
• Imagine that the interest rate on your savings account is 1 percent a year and inflation is 2 percent a year. After one year, would the money in the account buy more than it does today, exactly the same or less than today?
• If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?
• True or false: A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage but the total interest over the life of the loan will be less.
• True or false: Buying a single company's stock usually provides a safer return than a stock mutual fund.

On the National Financial Educators Council’s version, the average score for participants aged 15-18 years old is only 60.08%. These disappointing results serve as exhibit for a need for improved financial and economic literacy among members of the general public.

Most fields of science face challenges when it comes to communication and engagement with the general public. While this is perhaps most pressing for some fields of the natural sciences—for example, those scientists communicating climate change science—it also applies to topics in the social sciences, and in particular to those that guide policy.

A lack of financial and economic literacy does not only jeopardize the individual financial health of households, but also the health of the economy at-large. Be it a chronic lack of saving (a recent Google Consumer Survey found that 62% of American households have less than $1,000 in their savings accounts, and that 21% don’t even have savings accounts) or its implications regarding economic growth and the effectiveness of monetary policy, the ability of economic policymakers to effectively craft policy is hampered by the public’s misunderstanding—or simply lack of understanding—of the policies or the issues underlying them.

Indeed, many—both on and off the political spheres—call for strict audits of the Fed, and for this central bank to follow a policy rule, by which some formula would dictate the effective Fed Funds rate (as opposed to it being voted on by members of the FOMC). As any testimony by Chair Yellen would attest, the Fed faces much pressure to follow this rule, but such a process would severely hamper the Fed’s ability to take extraordinary action during times of crisis, or even of expansion.

After all, when the time comes to set policy, the Fed must be able to weigh different moving pieces and dynamic factors of the economy as they arise and evolve. A formula, no matter how robust or well of a fit to past data it may be, would never be able to deal as effectively with policy-setting—at least for the moment—as the power of human brains trained in Economics.

After all, many point out that well-known “rules” (such as the Taylor rule) would have likely implied negative interest rates during the financial crisis and ensuing recession of 2008-2009. Yet, at the moment, a negative interest rate is not part of the Fed’s arsenal for setting policy. As such, tying the Fed to only follow the prescriptions of such a rule would have implied a policy less responsive to the gravity of the situation (as the Fed Funds rate would have likely been set at the floor of 25 basis points, but without the option for quantitative easing as rolled out further in the crisis, or for forward guidance, two powerful tools employed by the Fed in this recovery).

Moreover, rules would have to follow data as observed historically and regressed with different econometric models, and be at the least informed by economic theory. Yet, even now we face a time where we see a tightening labor market, but persistently low inflation (a phenomenon many have referenced to call for patience from the Fed in raising rates). A model would thus likely respond inadequately to such moving forces—as traditionally and theoretically, an expansion implies lowering unemployment and increasing inflation. The Fed must be able to adapt to the future and to extraordinary circumstances, such as the ones we observe today. A rule would instead limit the Fed’s ability and flexibility in responding to crises.

Lastly, the Fed must be able to gently guide policy, while a rule might instead lead to abrupt changes, or lag the economy. By definition, a rule/ formula must be data-dependent and driven by what’s been historically observed. As such, a rule is almost exclusively backward-looking, so that policy changes may be mistimed, too strong or weak depending on the situation, or fail to adjust for future expectations.

All in all, rules and formulas—like algorithms in general—help simplify processes. But monetary policy should inherently not be simple, and should not follow a cookie-cutter process, as the economy is not itself a predictable mechanism. While more transparency from central banks is always welcome, the truth is that a rule would not benefit anyone in the economy, as policy would likely remain above the level of financial and economic literacy currently observed (thus, no one’s thirst for complete transparency would really be satisfied), a rule might be as or more error-prone than human policymakers (given the limitations in observing all the data and weighing the different factors appropriately, according to purely historical relationships and not evolving phenomena), the models used to determine the rule would likely face as much if not more criticism than the current human policymakers, and a rule might imply a limiting of the effectiveness of monetary policy (making our economy dangerously more policy neutral), as it allows agents in the economy to absorb information more quickly and expect changes in policy before they actually happen, as prescribed by the rule.

As even some Fed papers have laid out, the Fed can often be a bit of a black box. As such, economists and policy makers face a challenge in increasing the financial and economic literacy of the general public, such that their own policy recommendations and research results are more meaningful, fruitful, and effective. However, a rule to tie the Fed’s policy-making power goes too far in the direction of “increased transparency,” instead limiting the Fed’s ability to carry out its dual mandate. A happy medium between outreach to the public-at-large, simplified policy statements, and increased knowledge of the workings of economic policy would go a long way in bridging the gaps between economists and the laymen affected by the former’s policy actions.

Graduate School Application Process

Over the last couple of months, on top of working and trying to enjoy the city (now that I can properly do so as a graduate), I’ve been trying to put together all my materials for applying next Fall to graduate programs in Economics.

While that has spelled some lapses in my ability to write for this blog, it has given me a window into the world of academia and graduate schools that I didn’t fully appreciate until now. On top of reaching out to people who’ve already gone through graduate school and could help answer my questions, registering for some extra math courses, and crossing my t’s and dotting my i’s for materials such as my transcripts, my papers, etc., perhaps the most time-intensive portion of my applications so far has been the statement of purpose.

Trying to condense my background, my interests, and my aspirations for a PhD in Economics into several hundred words is certainly challenging. Moreover, trying to explain why each particular school’s program will allow me to fully pursue my interests can also be challenging—especially when trying to do so in only a few paragraphs.

Trying to do so has forced me to delve deep into the strengths of different schools in diverse fields of study, the particular areas of interest of their faculties, and—most importantly—what kind of research would be most viable, valuable, and original for me to pursue.

Trying to explain one’s passion for a subject—all while simultaneously describing why one wants to pursue graduate work, how one is qualified to do so, what research areas one would be interested in pursuing, what one aspires to do after obtaining a PhD, and why a school is a particularly good fit given all of the above—can be a daunting task. But it has challenged me to articulate in concise and clear terms why I’m up for the task of a doctorate in Economics—and to give a deeper look into the field that I’m trying to communicate I’m very passionate about.

Hopefully, in less than a year now, I’ll be pressing submit on my applications with a statement of purpose that conveys to each program that I’ll be a productive, passionate, and dedicated researcher, with all the tools in his belt to provide valuable contributions to the field of Economics.

The Fed’s Decision: On the Federal Funds Rate and Optimism

This Wednesday, December 16^th, members of the Federal Open Market Committee are widely expected to raise the Federal Funds rate—and with it, short-term interest rates—for the first time in nearly a decade.  While it is of course simple enough to come to an opinion when the choice seems much clearer—though many still remain skeptical of the appropriateness of a rate hike, and there are of course many risks and uncertainties—I am currently of the opinion that an interest rate increase is the proper course of action at this time.

While there are ongoing and vigorous debates in macroeconomics about the role of policy in the economy—in particular, whether fiscal and monetary policy are effective tools at all in a “policy-neutral” economy—there are several reasons why an announcement by Chair Yellen and the members of the FOMC regarding an increase in the Federal Funds rate is appropriate this Wednesday. I will try to list these reasons here, as well as acknowledge and potentially address some of the main concerns that arise with this potential action.

Why the Fed should raise rates:

• A higher Federal Funds rate is a sort of macroeconomic insurance policy, potentially pressing the brakes on the economy and slowing its momentum (the policy’s premium), but for the sake of more flexibility at a time when a stimulus policy is required (the payout).  Having an interest rate above 25 basis points provides a cushion and some wiggle room for potential further slowdowns.

• Whether we believe or not in the role of psychology and behavior in the strength of the economy, raising interest rates is a signal of confidence from the Fed in the economy, that may spur further confidence in the agents that participate in the economy itself. As learned in any introductory macroeconomics course, inflation (among other economic variables) can often be self-fulfilling. When people expect or believe the economy to be heating up, they may behave in a way that confirms and produces that very expectation.

• Most of the recent concern over the last few weeks has regarded falling commodity prices, which many see as a sign of weakness in the global economy. Coupled with still comparatively weak Eurozone and Chinese economies, many are concerned that we are still in a highly unstable situation. However, the Fed has expressed its belief that this downward pressure on inflation should abate with time. Naturally, there should be a floor to which prices of commodities—such as oil—should fall. When that process ends (at the time of this blog post, a barrel of crude oil is well below $40, as are its futures), there should in fact be an upward pressure on inflation. The performance of commodity prices should be seen as a temporary phenomenon, and one that is considerably supply-driven. As we know, production of crude oil by the United States is near record-highs, and the members of OPEC have not pared down their production targets to lower global supply. As such, falling commodity prices (in particular, oil) could be seen predominantly as a supply-driven phenomenon, which is less concerning in the immediate time span than the demand-driven view (where falling oil prices might signal a weakening in manufacturing, production, etc.).

• While financial stability is under the purview of the Federal Reserve, financial markets should not be the main consideration behind the Fed’s decisions. In fact, many of the notable movements over the last weeks in the prices of several important assets (the EURUSD exchange rate, bond yields, etc.) show that markets have long begun pricing in the effects of a rate hike, and widely expect the Fed to raise rates this Wednesday. Deciding otherwise at this point might be a negative signal on the strength of the economy. While there are of course valid concerns over the level of inflation, the labor markets and growth, the U.S. economy in particular is considerably healthier than it has been in nearly a decade (since the beginning of the recession in 2008 and the first rumblings of crisis in 2007).

• If we view inflation rates as tied (and potentially lagging) interest rates, raising the latter may in fact be a good way for the Fed to address concerns over disinflation and a potential deflationary spiral. Of course, we should not fall into the fallacy of believing that the Fisher equation—or generally the fact that interest rates and inflation rates are highly correlated—implies a causal relationship between these two variables. After all, the omitted variable here is likely that higher inflation rates follow a strong and vigorous economy, which may be accompanied by increasing interest rates as the Fed prevents overheating. But to the extent that prices follow increased costs of capital, and other factors provide a more causal relationship between interest rates and inflation, perhaps a hike in interest rates may help breathe further life into U.S. inflation.

• Wage growth, which has been closely observed as it is tied to and is a strong signal of inflation, should face upward pressure as the labor market tightens further. Concerns over the low labor participation rate are partly addressed by the beginning and continuing retirement of the large generation of baby boomers.

• "Creative destruction”: easy money makes risk-taking easier (the Fed is often blamed for not raising interest rates quickly enough in the years preceding the financial crisis of 2008, as low interest rates encouraged risk-taking in mortgages and other financial products), and allows for the inefficient survival of firms that—in a more competitive environment—would potentially go under. While the closing-down of firms and the subsequent loss of jobs is often not a positive development, if these firms are sluggish and inefficient, they can be a drag on the economy and prevent more innovative, entrepreneurial firms to take their place. Indeed, it can be as problematic to make running a business easy as it is to make it difficult; “creative destruction” entails that it is more optimal for inefficient businesses to not survive. Enabling them to survive means a weaker economy, less innovation, more complacency and deadweight losses on the economy. Less easy money and loans will mean literally “survival of the fittest” firms, which some might argue is how economies should thrive.

• Many have remarked on the abundance of excess reserves in banks. In a world where we perhaps see supply of loans (as opposed to demand) as the main driver of the amount of credit in the economy (meaning, a large determinant of how much loanable funds exist in the market is banks actually being willing to lend out money, which we saw was not the case during and immediately after the financial crisis), then raising rates may actually be an incentive for banks to increase their lending out processes, enabling a smooth flow of credit into the economy that might help counter any negative effects of a rate hike. Indeed, with higher interest rates the supply of loanable funds should increase, allowing us to increase our savings rate and, in the context of the Solow growth model, help propitiate a faster accumulation of capital.

• A slow, gradual tightening of policy should be good for the economy; the brakes need to be applied at some point and it’s better it be done smoothly and with warning (see criticisms of last crisis, how the Fed didn’t raise interest rates in time time). We wouldn’t want to raise rates too quickly, without warning, actually causing trouble for markets and consumers alike. The way the Fed has framed and given extensive forward guidance should ensure that expectations have been primed so as to avoid a major shock to the economy.

Of course, as with any other major policy action, there are significant risks and uncertainties. Perhaps the most cited concern by economists and commentators alike is a potential deflationary spiral, as an increase in interest rates provokes a slowdown in the economy (potentially a recession) and the vicious cycle of continuously falling prices (Japan presents a clear case-study).

To address this issue, it’s important to first gain some perspective. After all, the likely increase in interest rates is only a 25 basis point hike, which would then be followed by a slow, gradual increase that would likely follow the same guidelines the Fed has set with forward guidance.  Because of this new practice, in fact, the economy has absorbed and “priced in” the effect of this hike already. As such, this policy action should not actually be a “literal” shock to the economy.  Considering that many macroeconomic models view a role for unexpected shocks (for example, models like the Phillips curve, and generally rational expectations), the interest rate hike should ideally not have a major negative effect on the economy, as it has already been incorporated into our collective information set. Of course, this brings us tangentially to the topic of policy neutrality. After all, if the economy prices in and adjusts for this change in the first place, is the Fed actually able to provoke any changes in the real economy? That is a debate I’m likely not prepared to address—at least not at this time.

Another concern relates to the politics of the situation—some are concerned (on all sides of the political spectrum) that the Fed might provoke a change in the performance in the economy that will have real implications on the Presidential and Congressional elections next fall. To Democrats, a rate hike has the potential for a recession that would destroy any positive legacy regarding the Obama administration’s role in the recovery, and potentially make it more difficult for the Democratic nominee to win election to the White House (with all the subsequent policy implications that would entail). Republicans, on the other hand, are concerned that a delay in the interest rate hike would be a concerted ploy to aid the party in power by stimulating the economy further.

Of course, this concern should be easy (and highly critical) to assuage, as independence from political pressures is an incredibly important factor in the credibility of central banks and—in turn—the effectiveness of their policy actions and their ability to actually have an impact on the real economy. I think it should be clear enough that the Fed’s role is not to hamper or abet the political campaign of any one candidate or political party, and (while it might be necessary to do so) addressing these concerns directly might go too far in the way of granting validity to those who already criticize the Fed for lack of political independence. Validating these concerns is to accept that they are founded and pressing—which we would all like to think they are not.

Lastly, many are concerned about the dynamics of the Fed raising interest rates and, in turn, strengthening the value of the dollar, while the European Central Bank simultaneously continues and expands its own program of monetary stimulus that might further strengthen the USD. This, of course, plays into the recessionary fears, as a significantly strengthened dollar would reduce American exports, increase imports, and in turn, lower growth and GDP. However, this can also be seen as a positive for American consumers and for foreign investment, as the higher interest rates provoke a larger inflow of capital looking to invest in the United States.

I would like to end by once again providing some perspective, and perhaps some caveats. The action the members of the FOMC may take on Wednesday represents a long, careful deliberation process years in the making, and one that in the end may represent a comparatively small increase (likely 25 basis points) in the Federal Funds rate. Like with every policy action, there are risks and concerns. At some point, however, we must lift off. Now is looking better than it has in a while for it to happen.

This financial crisis and Great Recession has done a lot in the way of provoking a sense of pessimism and lack of confidence in the American and global economy. The repercussions of this crisis were indeed painful, far-reaching, and long-lasting, so any hesitation or skepticism at this time from both professional economists and laymen is understandable. Moreover, some may be concerned that the Fed is rushing into an action by simply trying to follow the psychological “clock” of moving early, before the end of the year is out. The turn of the calendar page could be seen as yet another failure—another year in which the economy has not fully and entirely recovered.

Yet, the economy has weathered both the original crisis and many other, smaller panics over the last years, and particularly over the last few months and weeks in the financial markets. I am confident in our policymakers, and optimistic that forward guidance should imply that with rational expectations, markets and consumers have absorbed all relevant rate hike information. Unemployment should not rise (especially given the strength in the labor market anyway), weak companies might be replaced by stronger and more innovative firms, and prices should follow the rise in interest rates as people ask for and obtain higher wages.

We can certainly expect some turbulence, but an increase in interest rates also represents a return to normalcy. In her testimony to Congress recently, Janet Yellen stated: “In closing, the economy has come a long way toward the FOMC's objectives of maximum employment and price stability. When the Committee begins to normalize the stance of policy, doing so will be a testament, also, to how far our economy has come in recovering from the effects of the financial crisis and the Great Recession. In that sense, it is a day that I expect we all are looking forward to.” Indeed, psychologically, Wednesday will be a day when we can all finally say: we made it.

After this entire discussion, the most important thing is that an interest rate hike perhaps means the return to one of the factors that’s been missing and, personally, I think is critical to the strength and performance of an economy: optimism. It is optimism that makes us move forward, take [healthy] risks, and progress. It is time for us to be optimistic about the economy once again, and Wednesday will hopefully be just a smooth and careful first baby step.

Polling and Measuring Economic Data

Anyone following electoral politics for the last couple of years will likely admit: opinion polling has definitely trended both less accurate and precise. As this article from The New York Times outlines, there are several factors underlying the decline in accuracy in public polling of election races. For the apolitical or those unconcerned with elections, this may not be a problem. But when it comes to economics, this may be a problem that should concern us all.

It is often easy to overlook data and its sources, and take the information we obtain for granted. Yet, behind the numbers on unemployment, growth and GDP, inflation, and other macro and micro variables, are strict methodologies that attempt to measure data as accurately and precisely as possible. These methodologies are of course oriented to ensure large random samples when necessary, and generally to avoid bias and ensure consistency in the variables that organizations and government agencies report on a regular basis. Some of these methods—such as seasonal adjustments—are more familiar than others. But the problem is that, if standard and tested methods are failing when it comes to measuring political sentiment, those economic variables that take in the public’s answers and opinions may be inaccurate as well.

Most economic variables are measured very consistently over time—such as unemployment, by interviewing a set number of households over a time period—and generally, since economic surveys try to capture facts on the economic situation as opposed to opinions, there should in theory be less of a concern than there is in political polling.

However, many other variables cited frequently both by the media and practicing economists—such as consumer confidence, indices of job creation, etc.—rely on the opinion of those polled (which may not be a random sample or not reflect a consistent sample across time) to less clearly defined questions (i.e. questions such as “is your company hiring?” “is the economy headed in a good direction?” “rate the strength of the economy” that might have much less objective criteria or set of answers). Moreover, the methodology to ask these questions often does not rely on the sophisticated methods used to measure other economic variables, such as the Current Population Survey.

As such, the use of these measures to gauge the strength of the economy, potentially define economic or public policy, or sway the outcomes of elections, can be highly problematic. While Economics is a rigorous science, and policy-making an intense study of all the factors in play, how we measure the economy has always been a topic of discussion, and one that we should continue to examine carefully—particularly regarding the sources and, in turn, the accuracy and precision of our measures. From the criticism of economists—including Nobel Prize laureate Joseph Stiglitz—regarding GDP and our measures of welfare, to the surprising lack of accuracy in political opinion polling running up to electoral events, how we measure the data around us should be as important (if not more) as the applications we find for that data. After all, without ascertaining the reliability of the data itself, all inferences obtained from that data should be moot points.