Here are three things I think I think you should be reading:
1) Here’s a very smart piece by Jesse Livermore over at Philosophical Economics. Jesse questions the validity of backtesting, systematic approaches and the importance of looking into these approaches with a grain of salt. I’m a big fan of well reasoned skepticism in finance and economics and Jesse always does a nice job of making you think deeply and thoroughly about ideas.
Of course, a backtest can tell you whatever you want it to say. Whether it will hold up in the future is a much murkier issue. Backtests are fine and can provide clarity about the methodology one is utilizing, but if the underlying principles utilized to construct the foundation of the strategy are flawed then you’re going to run into problem regardless of what the backtests make you think about future returns.
2) Here’s a very smart piece by Matt Klein of the FT discussing the Fed rate hike and the similarities to 1998. Matt says the Fed is trying not to make the same mistake they did back then when they eased policy and exacerbated asset bubbles and private investment. As I’ve stated in the past year, this environment does indeed look a heck of a lot like 1998. Matt compares and contrasts the two environments and says that the Fed might be trying to make up for the 1998 mistake.
I’m not sure I’d blame 1998 on the Fed, but it does appear as though financial instability is playing a big role in the Fed’s current rate decision. That would certainly be a reasonable argument for a rate hike, but I still think the Fed should be erring on the side of caution here. They’ve implicitly tightened policy by doing nothing (i.e., forecasting a hike) so I don’t see why they even need to act at this point. Especially with the deflating credit markets and foreign currency markets….I wouldn’t be one bit shocked if they raise a few times and then end up cutting inside of a 24 month period….
3) Here’s a good piece in the WSJ by Josh Zumbrun on the confusion over low inflation. Here’s a great quote:
“There’s no way in hell anybody reasonably predicted, using the mainstream models, that you would end up with inflation this low,” said Adam Posen, the president of the Peterson Institute for International Economics, a think tank with an international focus.
It seems to me that the problem might be these mainstream models because lots of heterodox economists have been predicting low inflation for the last 7 years. But that’s what you get when you rely on concepts like NAIRU and the Natural Rate of Interest. You get theories that look good on paper, but can’t really be proven empirically. As a result, we’ve got policymakers who are incessantly focused on sacrificing full employment in order to avoid even a hint of inflation. It’s crazy to think that even Janet Yellen, who looked like a policy dove not so long ago, is hell bent on raising rates at a time when unemployment is so low AND inflation is falling. But she’s using the same failed mainstream model that says surging inflation might be right around the corner….