Four Regimes for FedOS 1.0

In prior posts (see the Notes below), I have explored the question of whether the US Federal Reserve could benefit from more automation and transparency. In this post I look at the question of whether automation could help identify different Crises Regimes in addition to Business-as-Usual (BAU, where automation is likely to work quite well).

Using Principal Components Analysis (PCA, see the Notes below and the Boiler Plate) I have identified a Reaction Function (FED) for each of the four scenarios: FED1 = BAU, FED2 = Full-Employment GDP Controller, FED3 = Financial-Inflation Controller and FED4 = Inflation Controller. The Control Functions are plotted above.** Over time: FED1 (BAU) increases but hits a peak in 2010, FED2  shows numerous cyclical peaks, the largest being after 1980, FED3 is relatively stable but peaks around 2010 and FED4 is relatively stable without peaks.

The next question is "...what action the Fed has taken historically during shocks". The Shock Decomposition diagram above (created by the FED model in the Notes) shows two regimes in which the Fed raises the Fed Funds Rate (FFR), Business as Usual and Inflation, and two regimes in which the FFR is decreased, Unemployment and  Financial Inflation. In general, these crises happened at different times historically so the Fed was not conflicted about policy directions.

Another point to notice from the Shock Decomposition is that the FFR effects are small except for the Inflation controller. And, in another post I have show that FFR changes have small effects on the economy (here).

These results do not mean that the Federal Reserve is ineffective. A major function of the Federal Reserve to regulate the US Banking System. Manipulating the FFR is one policy measure among many that are important to a stable Banking System. The Fed saved the Banking System during the Subprime Mortgage Crisis (although it can be argued that stronger Banking Regulation could have prevented the crisis in the first place). Without the Fed, economic consequences would have been much worse.

Notes

• Could the Fed be replaced by a Computer Program? No, but more automation, communication, public input and transparency would help (and could be a model for other Federal Agency reform).

Reaction Function Index

** The Reaction Functions, plotted at the beginning of this post, are independent (by construction). Notice that the FED2 function (Full-Employment GDP Controller) does a very good job of tracking Crises in Late 20th Century US Economic History:

• Great Inflation Google AI reports that "Inflation in the 1970s was caused by a mix of supply shocks (especially oil crises from OPEC), expansionary fiscal policies (Vietnam War, Great Society spending), and monetary policy errors, leading to "stagflation" (high inflation and unemployment)".
• Dot Com Bubble The tech–media–telecom (TMT) bubble and low interest rates led to a speculative frenzy on Wall Street.
• Subprime Mortgage Crisis A multinational financial crisis that occurred between 2007 and 2010, contributing to the 2008 financial crisis and required the Fed to invent new programs for dealing with the fallout. 
• COVID-19 Pandemic Caused "severe social and economic disruption" and required Fed Action.

All these crises require Fed policy action and the FED2 index captures the full extent of each crisis.

Control Functions with independent Regimes and empirical weightings can be created using Principal Components Analysis (PCA) on standardized data (see the Boiler Plate): FED1 = (Overall Growth in the Indicators), FED2 = (0.9736 LU - 0.206 GDP) Full-Employment GDP Controller, FED3 = (0.8534 BANK1 - 0.381 GDP - 0.3165) Financial-Inflation Controller, and FED4 = (0.7247 P.GDP. - 0.682 GDP) Inflation Controller.

Banking Index

An index of Banking Stability can be created using the following indicators: FB.BNK.CAPA.ZS = Bank Capital to Asset ratio, FB.AST.NPER.ZS = Nonperforming Loans, and FB.CBK.BRCH.PS = Bank Branches.  BANK1 = (Overall Growth with relatively equal weightings), BANK2 = (0.847 FB.AST.NPER.ZS - 0.462 FB.CBK.BRCH.PS - 0.261 FB.BNK.CAPA.ZS) Nonperforming Loan Controller and BANK3 =  ( 0.743 FB.BNK.CAPA.ZS - 0.657 FB.CBK.BRCH.PS) Branch Bank Capitalization Controller.

 

Over time, in the graphic above, the BANK index captures the Dot-com Bubble, the Subprime Mortgage Crisis and the resulting Dodd-Frank Legislation.

It is interesting that the FED4 Inflation Controller explains very little variance as a policy regime (Less than 0.05%, graphic above). Given that Inflation Hawks are constantly warning that Fed actions are inflationary, the historical record does not show FED4 as an important Crisis Controller.

ChatGPT list somewhat different non-BAU crises and suggests other policy responses:

Establishing policy actions to take during new and novel financial crises is an important and continuing responsibility of the Fed the the Fed Open Market Committee (FOMC).

FED Model

The state space mode above was used to generate the Shock Decomposition in the text. The model is nonlinear and stable.