Episode 20 - Colorful Books, Part II
This week we continue our series on the colorful books of the Federal Reserve. One of the signature decorations of the Christmas holiday is colored lights. When you think of Federal Reserve publications - colorful is probably not the first word that comes to mind. But this series will change that!
Welcome to The Bankster Podcast. I’m your host, Alexander Bagehot, and this is Episode 20 - Colorful Books, Part II. Every episode we dive into what I call The Centralverse! The incredibly fascinating and ever more consequential world of central banking.
The outline for today’s episode started out simple. It was going to be pretty short and concise. The news story I was planning on covering had already been widely analyzed and the history section was going to be the conclusion of the Colorful Books series, a brief overview of each of the remaining four colorful books in the Fed’s rainbow of publications. However, I received a great question from a listener that highlighted an important nuance of the Dot Plot which deserved a deeper look. Then as I was doing the research for the overview of the Colorful Books I found some additional material that provided so much great content that I just couldn’t fit it all into one episode. So today, like last time, we’ll cover just one new color in the history section.
I recommend going back and listening to Episode 19; Colorful Books, Part I if you missed that one. It’s an introduction to the Colorful Books and tells the story of the Beige Book. Today’s episode is Part II. We’ll talk about one of the books that is no longer in print. Then next week I will continue the series with a Part III.
Ok, that’s the schedule, let’s dive into the news.
Last Thursday, at 2pm Eastern time the Federal Reserve’s FOMC announced that they would increase the target range of the Federal Funds Rate by 25 basis points, which means by one quarter of one percent. The Federal Reserve Bank of New York’s market trading team will now buy and sell on the inner bank lending market to make sure the interest rate is between 0.5% and 0.75%.
This is only the second time the base interest rate that the Federal Reserve controls has been raised in over a decade. The first time was a year ago, December of 2015. Before that the last rate raise was in June of 2006, shortly before the beginning of the Great Recession. So considering the rate hike was only the second in a decade, it didn’t get very much publicity. That is partly because the move was expected. Like most things in the media today, if it’s not a surprise it doesn’t get covered.
A listener named Jackie did write in however and ask about a few points he had read in a Wall Street Journal article about the Dot Plot that accompanied the announcement about the rate increase. For those of you who don’t recognize the term Dot Plot, head back to Episode 9 for a full description of not only what the Dot Plot is but also where it came from and how it fits into the broader narrative of Central Banking communications.
Back in October Narayana Kocherlakota, the former President of the Federal Reserve Bank of Minneapolis wrote an article for Bloomberg News about the Dot Plot. Jackie’s question had to do with a subtle nuance in the interpretation of the Dot Plot that is super important yet poorly understood. Kocherlakota puts it this way, “The Dot Plot has two big perception problems.”
Jackie’s question had to do with an article in the Wall Street Journal that, referencing the latest Dot Plot, claimed that the Fed, and I quote from the title, “Anticipates 3 [interest rate] increases in 2017”.
This is a very misleading title and is the result of a simple misunderstanding of what the Dot Plot says and what it does not say. It illustrates quite well the issues that Kocherlakota discusses in his article so I’m going to let him continue, “the first [big perception problem] is the belief that [the Dot Plot] reflects officials' interest-rate forecasts. It doesn't. Rather, it shows what each participant thinks the Fed should do, based on his or her individual forecast of how the economy will evolve and what the optimal response would be.” So did you catch that? For example, if a policy maker and member of the FOMC puts down his or her Dot at 1.3% for 2018, they are not saying that they predict that the interest rate will be 1.3% in 2018. What they are saying is that they believe that interest rates should be 1.3%. Or in other words, they believe the economy would be best served if the interest rate was 1.3% in 2018. Do you see the difference. It's the difference between “This is what I think is best.” And, “This is what I think will actually happen.” The Dot Plot is the former. It's a great way to see how wide the range of opinions are among the members of the FOMC.
The second “big perception problem” is born from the first. It's the misinterpretation of the Dot Plot as a commitment for future action. The consequences of falling prey to this perception problem is much more severe than the first. This is because businesses and banks have to make decisions on a daily basis that involve estimating what the future interest rates will be. Banks make loans today based in part on what they think interest rates are going to be next month, next year, and in future years. And who has the most influence on what interest rates will be? The Fed of course. You can imagine the serious, negative consequences of interpreting the Dot Plot as a commitment to future action. Have you heard the phrase, “garbage in, garbage out”? (My undergrad macro economics professor actually used the acronym GIGO.) If bankers and business leaders are making decisions and using the Dot Plot as an input that says, “this is what the Fed will do” they are not going to get accurate results out of their models. One final piece of evidence to illustrate the claim that the Dot Plot is not a commitment to further action is that all of the FOMC members get a dot. At full capacity this means 19 dots. But remember that only 12 of those dots get to actually vote. On the Dot Plot you can't tell which are voting dots and which are not.
So, Jackie, you are not alone in being slightly confused by claims like those in the article you cited. In summary the Dot Plot is not a prediction nor is it a commitment.
Now, I'm not suggesting that the Dot Plot is garbage. It's very useful in understanding what the range of opinions is on the FOMC. But remember those two perception problems next time you read or hear about the Dot Plot.
Kocherlachota finished his article by suggesting a few ways in which the Fed could improve the Dot Plot. If you sign up for the show notes to the podcast at www.thebanksterpodcast.com I'll send you a link to Kocherlachota’s article.
Alright, onto the next colorful book from the Fed’s rainbow of publications.
The rainbow includes six different books. On Episode 19 we introduced the most popular and most widely read - the Beige Book. But before we start talking about the others I first want to mention that if you can’t keep track of all of these colors, which books are current and which are out of print, no worries - I have created an easy to read chart that explains the ins and outs of all of the Colorful Books. Sign up for the show notes and I'll send it directly to you.
Ok, the publication for today’s history section is the Red Book. Let’s start with a few basics. The Red Book was the precursor to the current Beige Book. It was started in May of 1970 and was published for every FOMC meeting until June of 1983. The idea was for the Federal Reserve Bank presidents to formalize, standardize, and share information about the economic conditions of their particular district with the rest of the FOMC - we’ll explain that in more detail in just a moment. The document was confidential and classified and therefore shared only with members of the FOMC and their direct staff. Also, like its successor, the Red Book contained qualitative information.
And that's about where I was going to end the section on the Red Book until I came across a fascinating article written back in 1999 by some economists from the Minneapolis Fed. It was an incredible read and provided a treasure trove of inside information about the Red Book and the Beige Book. The article is actually called, “The Federal Reserve’s Beige Book: A better mirror than crystal ball”. This is a great read and a perfect follow-up to the Colorful Book series so far. I recommend adding it to your reading list for your holiday flight, drive, or post family meal, pre nap relaxing time.
So let’s talk a little bit more about where the idea for this Red Book even came from. And like many important things in the Federal Reserve’s history, it starts at the meetings of the FOMC, where the important monetary policy and interest rate discussions are had and decisions are made. William McChesney Martin had been the Chairman of the FOMC for nearly 20 years when he left the office. He had been a major player in the Treasury Fed Accord (Episode 7 tells that story). He had also been a different type of Chairman. He let others speak first and went around the table, giving each of the other 18 members a chance to share their thoughts, research, and opinions before making his decision (a practice that would return to the FOMC with Ben Bernanke).
In 1970 however he was replaced by Arthur Burns, whose leadership style was quite different. The Minneapolis article says, “Burns was not a consensus builder when it came to Monetary Policy…[He] did exactly the opposite. He began his first meeting by saying he would not be bound by the old ways and that there would be no set order for discussion”. There was another change that he would implement that requires us to jump just a little bit farther back in time.
One of the fundamental principles that has governed the Federal Reserve since its inception is the idea that it would be a federal system. When you think of the word federal, what comes to mind? If you're like most people you hear the word federal and think of Washington DC or the central government. However, the definition of federal is, “having or relating to a system of government in which several states form a unity but remain independent in internal affairs.” (Google definition).
How exactly federalism was implemented at the Fed changed quite a bit in the first half century of its existence, but the idea that there should be representation from across the country was always a vibrant part of the decision making process at the highest levels. The bank presidents brought to the FOMC meetings a wide breadth of information from their district. As we learned in Episode 18, the very boards of directors of the Reserve Banks are industry leaders in their area. The Bank Presidents have a wide network of business leaders, labor leaders, manufacturers, farmers, and everything in between. Via these contacts the Reserve Bank Presidents gather a deep understanding of their local economy in the form of experiences, concerns, and unique perspectives that their contacts share with them. In other words, they gather a large amount of qualitative information. Information and data that isn't measured by numbers.
Before Arthur Burns this qualitative information was brought to the FOMC by each of the Reserve Bank Presidents and shared at the meeting in the go-around comment section of the agenda. However, and again I quote from the Minneapolis article, “Burns...decided it would be a more efficient use of the FOMC's time to have the reports on district conditions prepared in advance and compiled for the Committee's edification.”
This had the effect of formalizing the qualitative gathering of district information and contacts and came bound with a red cover, “Thus was born the Red Book”.
The Red Book would be prepared for the FOMC meetings for over a decade. And just as interesting as the book’s inception is so is its end. In 1983 a US congressman named Walter E Fauntroy, a representative for the District of Columbia, requested that the Green Book be made public. We’ll talk about the Green Book in a future episode of our Colorful Book series. The Green Book contained the economic models and forecasts that the Fed economists were using to help formulate Monetary Policy.
The Minneapolis article puts it this way, “the Board [of Governors] deemed this unwise and the Red Book was offered in its place.” And surprisingly, that was that. All of the references to specific business and people were redacted from the historical Red Books and going forward the new, publicly available book was given a new cover of a different color. At first it was referred to as the Tan Book. But would soon become known as The Beige Book. Besides being available to the public and given a new cover, the new Beige Book would be different from the Red Book in one other way. It would be released to the public two weeks before the FOMC meeting instead of brought directly to the meetings. The Minneapolis article describes it this way, “It was thought that by building in a two-week gap, the media and others would recognize that the information was not timely and, therefore, did not have a major influence on policy.”
So that's the Red Book, and some additional bonus material to go along with last time’s episode on the Beige Book.
Fed publications and communications are evolving. It was fun today to see how one Fed publication, the Red Book, came and went and also to see how a current publication, the Dot Plot, is still in the process of changing and adapting how it's seen and interpreted. This is what studying the Centralverse is all about.
As always, send in your comments and questions about the Centralverse or the Bankster Podcast via email (email@example.com) or Twitter or Facebook. Open up your podcast app right now and give the podcast a rating and a review.
If you go to my website, www.thebanksterpodcast.com you can sign up to receive the show notes to today’s podcast and every future podcast directly in your inbox. It’s a great way to follow up on the content that we discuss and to look deeper into the Centralverse. I’ll include a few excellent links that helped me to create this episode, including the link to former President of the Minneapolis Fed, Narayana Kocherlakota’s article about the Dot Plot. The show notes to this episode will also include an easy to read chart that explains all five of the different Colorful Books that the Fed has published, past and present.
Today’s episode was written, edited, and produced by me, Alexander Bagehot. I dedicate this episode to the original founders of the Federal Reserve - Happy 103rd Birthday. And to everyone else, thanks for listening. I’m Alexander Bagehot, and I’ll see you next time on The Bankster Podcast!