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 Loss Function (L) for each of the four scenarios: L1 = BAU, L2 = Full-Employment GDP Controller, L3 = Financial-Inflation Controller and L4 = Inflation Controller. The Loss functions are plotted above. Over time: L1 (L+BAU) increases but hits a peak in 2010, L2  shows numerous cyclical peaks, the largest being after 1980, L3 is relatively stable but peaks around 2010 and L4 is relatively stable without an peaks.

The next questions is what action the Fed has taken during shocks. The Shock Decomposition diagram above 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.

The other points 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 save 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).
• Four Regimes for Fed OS 1.0 The main problem with totally automating the Federal Reserve is what to do during Economic Crises. In addition to Business as usual (BAU), three crises regimes can be identified statistically where human judgment is needed.

Loss Function Index

A Loss Function with independent Regimes and empirical weightings can be created using Principal Components Analysis (PCA): L1 = (Overall Growth in the Indicators), L2 = (0.9736 LU - 0.206 GDP) Full-Employment GDP Controller, L3 = (0.8534 BANK1 - 0.381 GDP - 0.3165) Financial-Inflation Controller, and L4 = (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 the L4, the Inflation Controller, explains very little variance as a policy regime (Less than .05%,graphic above). Given that Inflation Hawks are constantly warning the Fed actions are inflationary, the historical record does not show Inflation as an important Crisis Controller.