With the latest data on core PCE inflation, I get to close out a forecast of 4 years of inflation data. The monetary information equilibrium model turned out to be biased low to almost the same degree the FRB NY DSGE model was biased high in the last year of the forecast period (-40 basis points versus +46). Nearly all of the error in the DSGE model can be attributed to the assumed return to 2% core PCE inflation. If it had instead predicted a return to 1.7% core PCE inflation, it would have performed almost perfectly.
In fact, the constant 1.7% inflation model did perform almost perfectly, which is excellent news for the dynamic information equilibrium model that predicts a constant 1.7% core PCE inflation in the absense of shocks. I'll define "good" performance relative to the constant model; with that metric the information equilibrium and DSGE models performed poorly.
The poor performance of the monetary information equilibrium model is in part behind my recent post on money as aether. Like a lot of people getting into economic theory, I was susceptible to the "money" view and one of the first models I produced was a "quantity theory of money" where
with k(t) falling over time. The M in this case is M0 (i.e. notes and coins) since every other measure (M1, M2, MZM, etc) worked terribly even after allowing k = k(t). It is now apparent that the k(t) in the model (1) above was accounting for the dissipation of the major demographic shock in the 1970s, and instead of continuing to fall the shock faded resulting in an underestimate of inflation.
So I consider this model rejected and it will get a frown-y face at the prediction aggregation link. This allows me to shed the last vestiges of my adherence to the paradigm of money. This model, which would have outperformed the Fed's so-called P* model using data available at the time (mostly because that linear extrapolation of k(t) from 1990 where the demographic shock was still fading was still an accurate approximation) as well as the various (monetary) models tested by Rochelle Edge and Refet Gurkaynak in 2010, will be laid to rest.
I will say in my defense that it only took me 4 years of looking at the data to reject monetary explanations of macro observables like inflation.
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Update 30 January 2018
Here are the comparable dynamic information equilibrium core PCE inflation model graphs (both with and without the 2014 shock implied from NGDP data):
I love seeing the evolution of your ideas on this.
ReplyDeleteThanks Tom.
DeleteYour first figure's legend says that the Fed's DSGE is in red. I don't see it.
ReplyDeleteIt's in the figure below; the top figure is just the monetary information equilibrium model on its own (forgot to change the plot title).
Delete"forgot to change the plot title" ... I figured as much.
DeleteAppreciate the level of intellectual honesty needed to post this.
ReplyDeleteCheers Todd.
DeleteThe data supports rejecting monetarism that relies on monetary aggregates, bit not market monetarism, correct? You've demonstrated that market monetarism lacks empirical support and that it's too easy to always explain away failures to hit targets as due to central bank intentions or incompetence , but I don't think makesm monetarism's been refuted.
ReplyDeleteI am open to the idea that there are sociological factors where most market agents believe monetary factors control the future path of the economy and will therefore adjust accordingly. For example, the Fed dropping to zero interest rates and engaging in QE could have mitigated the size of the Great Recession because people believed it might help and stopped panicking (in information equilibrium language: agents stopped being correlated in state space due to panic and returned to doing their own thing mitigating the non-ideal information transfer).
DeleteI think Sumner himself mentioned some version of this theory where he said that if market agents were Keynesians then Keynesian economics would be the "right" theory.
This theory isn't really falsifiable with economic data; you'd need sociological/neuroscience data (surveys of beliefs, EEGs measuring agent's responses during a recession). At this point I just say I don't know what causes or ends non-ideal information transfer/non-equilibrium shocks. However, these periods also seem to be sparse in the time series (if they were more frequent then the information equilibrium approach would be contentless -- this is also related to why the bitcoin model is useless for forecasting: non-equilibrium shocks are too frequent).
I mostly agree with you, but I think it's possible to conceive of ways market monetarism could be refuted, without appeals to psychology. For example, if a central bank near the ZLB began simply creating money sans asset purchases by computer program and providing everyone in the country with a set amount of new money on a set schedule to produce, say 8% more money each year, and continue indefinitely, and prices fail to move upward in rough proportion, that would begin to make me think market monetarism is being refuted.
ReplyDeleteOf course, it's not realistic to think anything like that will happen, but the point is merely that it's possible to conceive of ways to test the model at the macro level.
First, let me say that just conceiving of ways to test a model does not improve the Bayesian prior the model is correct and does not count as any sort of validation.
DeleteNow once you get much above the 8%/y level of inflation, you're nearing the breakdown of the connection between money and real assets and the quantity theory starts to take over (or see here).
And this kind of thing can actually happen. In physics there is a good analog. If we think of high energy QCD as high inflation QTM. At high energy (~ 1 GeV), the strong force is all about quarks (QCD). But once you get down to say ~ 100 MeV, you can pretend that quarks don't even exist and you can just talk about hadrons.
So using quantity theory above 8%/y would be a vestigial bit of monetarism you're hanging onto?
Delete"Hanging onto" isn't quite the phrase I'd use. For cases where base money expands at a rate r >> 10%, the quantity theory is a decent model of inflation. I make no claims about whether that inflation has a positive or negative effect as demand management (i.e. "monetarism" = demand management via monetary policy).
DeleteGood point.
DeleteIf a government/central-bank were to set out to cause high inflation (> 10%) on purpose, what do you suppose is the minimum they could do to cause that (if anything)?
DeleteSumner would probably say "make a credible announcement of their intention to do so (specifically wrt the central bank)" ... and thus zero "concrete steps" would be required.
DeleteTom,
DeleteYes, market monetarism doesn't appear to be falsifiable under any circumstances reasonably expected to occur in the foreseeable future. Jason has demonstrated this weakness better than anyone else I've seen.
I agree on the first point. However, it is better that a model is at least hypothetically testable than not.
ReplyDeleteCan go lower than 8% annual money supply growth, on your second point, and the test won't be perfect under any circumstances.