Consistent with our and the market’s expectations, the Federal Open Market Committee (the FOMC) left the Fed Funds rate unchanged, at 0.25%‐0.50%. Despite the inaction, the Statement and Summary of Economic Projections provided fireworks for what was expected to be a rather benign event.
The FOMC decided the most prudent approach to formulating the September statement was to keep the outlook for the US economy positive, but indicate that further evidence was needed to enhance their case before another rate increase. The overall tone of the information released today was mixed. Some parts of the statement struck a more hawkish tone: near‐term risks were considered balanced, three regional bank presidents dissented and the case for tightening “has strengthened.” On the other hand, the Summary of Economic Projections indicated a much slower pace of rate tightening (particularly in 2017), the median forecast for core inflation in 2017 was downgraded, and three FOMC members saw no additional rate hikes as appropriate this year.
We can break the Committee’s statement into three parts:
Finally, three members of the committee, Esther George, Loretta Mester, Eric Rosengren (Presidents of the Kansas City, Cleveland and Boston Federal Reserve Banks) dissented in favor of a rate hike at this meeting. While this is not the first time Ms. George has dissented from the broad group, Mester and Rosengren dissented for the first time. Rosengren’s dissent was particularly surprising given his tendency to focus on downside risks.
The Summary of Economic Projections showed marginal changes on the economic front. The Fed’s long‐run forecasts on potential GDP were downgraded (0.2%), however the path toward achieving their other objectives remained roughly similar to the June submissions. The FOMC also reduced their expectations for GDP growth in 2016, which reflected more of a mark‐to-market after a rather weak H1. The Fed continues to see further improvements in the unemployment rate, despite the recent leveling off. The path of inflation was little changed, but the FOMC is closer to achieving their 2% objective. The Fed also released the “Dot Plot”. With the introduction of 2019 forecasts, the path of the Fed Funds rate is even flatter than previously communicated. The median long‐run Fed Funds rate was reduced by 0.125% to 2.875%. The 2016 forecast reflects only one rate hike by year end. The expected tightening in 2017 was slashed by 0.5% and the forecast is for only two rate hikes over that time period.
At the press conference, Chair Yellen remained a bit more optimistic in light of recent labor market developments, the lack of follow‐through from the EU referendum, and a desire to achieve a rate hike before year end. The Chair suggested the Fed could remain more accommodative in future years to achieve their medium term objectives. With short‐term rates near zero, an inflation overshoot could be managed more effectively than a slowdown in the economy.
In these pages I’ve written frequently about the anti-establishment and anti-globalization voter sentiments, which are political positions that appear to be self-defeating when viewed through the (conceited) prism of classical economics. My conclusions have been that due to the magnitude of inequality, old economics may simply no longer apply. Colleague Matt Pallai, in pointing me toward the Ultimatum Game, reminded me that elements of human nature are at play as well, not just pure economics.
This week I want to use the Ultimatum Game to examine these characteristics in human nature which seem to both intensify the anti-establishment sentiment once inequality reaches a certain threshold, as well as contribute to acceptance of the anti-growth impulse of a vote which may not be rational purely based on economics. The game works as follows. There are two players. Player 1 is given a sum of money, say $100, and asked to split the sum with Player 2. Player 1 alone decides how much to keep and how much to offer to Player 2, but if Player 2 rejects the offer as too low, both players get nothing. Based purely on economic rationality, any offer above zero should be accepted by Player 2, because $1 is better than nothing. In practice, offers below about 30% of the total are routinely rejected by Players 2 in experimental settings. Offers around 50% of the total are routinely made by Players 1, which is to say there appears to be some endemic concept of “fairness” in human nature and culture, and opinions vary on what is fair.
I think the parallels between the experimental findings in this simple game, and realities facing our societies and economies today are pretty stark. The Ultimatum Game, in one sense, is about forced redistribution of unequal wealth with a penalty for getting it wrong. In the real world, redistributionist policies aren’t merely acceptable, but rather are integral to the smooth functioning of societies around the world. “Redistributionist” is a crass word, but this is, after all, simply what taxation in a democracy is. While there are certainly many individually regressive taxes, the universal philosophy of taxation as a whole is fundamentally a progressive one. The debates are about how much progressivity is actually present and how much is optimal for growth. Democracies of the world typically do not fund their budgets solely through flat income taxes or a flat VAT. Instead, some mix of consumption, progressive income, and wealth taxes are worked out amongst all the Players. Even in the nations with flat-rate income taxes (none are highly developed democracies), the high income earners undoubtedly pay more in tax than they receive in benefits from their governments.
In the Ultimatum Game, both players have to correctly perceive the chosen offer as “fair enough” to prevent the (purely financial) loss of shared economic misfortune. Experimentally, there are a range of frequent outcomes, which feels as natural as the dispersion of opinion on what, if any, policies should be used to stem the tide toward winner-take-all income inequality. A total rejection of redistributionist policies in the real economy eventually results, in the extreme, with owners of capital (Players 1) running out of consumers (Players 2) to provide return on their capital and the economy grinds to a halt, much like the rejection outcome in the game. Once inequality reaches a certain level, or taxation policies seem insufficiently “fair,” anti-establishment sentiment intensifies, even if the near-term economic implications are negative.
Secondly, the rejection of offers below the 30% threshold, which occurs regularly despite ensuring that an obvious economic benefit (free money) is rejected by Player 2, feels quite similar to the Brexit vote and the rise of protectionist rhetoric in the face of profound evidence that it makes economies worse off financially. So even though I have argued in the past that anti-globalization voters might be right—that today’s economies are different enough from the past that formerly obvious economic truths may no longer apply—more simply it might be just that pure financial gain is not always the determinant of human preferences. That’s certainly true in the Ultimatum Game results.
My gut says we’re witnessing a bit of both: old economics encountering some new realities, and citizens not voting just their pocketbooks. Regardless, when faced with choices about how to share precious resources or whether to intentionally endure economic hardship in the name of progress, near the boundary of success and failure, considerations of altruism, thrift, schadenfreude, empathy, fairness, and punishment all influence the outcome in addition to pure finance. The politicians are starting to understand this, a trend which is set to continue, and now we economists need to get on board.
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