Randomize the Fed

Thu, May 21, 2009 | Jared Woodard

Economy, Fed

Felix Salmon offers a tongue in cheek solution to the problem of business leaders assuming the Fed will act to prevent recessions:

How to fix this? Is it not the job of the Fed to try to minimize the severity of recessions? One alternative approach would be to consider it to be the job of the Fed to minimize the severity of the worst possible recession. What would happen if, for instance, rates were set using a random-number generator? Every FOMC meeting, some kind of virtual die would be rolled, moving rates up or down even if that was the opposite of “correct” monetary policy. The resulting uncertainty would force people to take a more defensive stance at all times, just in case rates went sharply upwards — even if the probability of such a rate hike was quite low.

Maybe monetary policy is a bit like optimal poker strategy: a certain percentage likelihood that you’ll do this, a certain percentage likelihood that you’ll do that. The Fed governors can then release a decision saying, essentially, “we plugged in a 10% chance of a 50bp cut, a 50% chance of a 25bp cut, a 25% chance of keeping rates steady, and a 15% chance of a 25bp raise, and rolled the electronic dice; guess what, we we ended up with the 25bp raise”.

OK, so that’s probably a silly idea. But some element of uncertainty is I think useful in monetary policy. [link]

Lord knows that approach would make Eurodollar options a lot more exciting.

I am not an economist, but I think there’s really something to this. Part of the problem with the US economy seems to have been that businesses were optimized to a scenario in which the Greenspan/Bernanke put was always in effect and was always efficacious. Troubles came when we inevitably encountered a scenario that overwhelmed the optionality of the Fed. (This fits generally with a Taleb-style account of agents being blind to the most disastrous sorts of risk.) So a Fed that causes businesses to focus less on aggressive optimization of their operations now, and more on defensive preparation against adverse rate hikes later sounds like an entity that could help reduce systemic risk, instead of being a major cause of it.


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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

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