1/1/19 –

On 12/31/18 the S&P 500 closed at 2507, resulting in a total return of -4.38% for the year. According to the November, 2018 Fed Open Market Committee, “…the labor market has continued to strengthen and that economic activity has been rising at a strong rate.” This observation correlates with the fact that, while bank lending was stagnating prior to the Great Recession of 2008, lending is now growing strongly.

But in the month of December, the S&P 500 declined by 9.1%, a worse December performance than the 6.0% December drop in 2002, giving investors a lump of coal in their stocking. The 12/24/18 NYT notes, “…the biggest worry for 2019 is not so much that…disruptions (are) so large to cause a recession. The real fear is that shaky policy allows small shocks to create a broader crisis of confidence.” For both the real and financial economies, confidence matters.

In The General Theory (1954) Keynes wrote, “The state of confidence…is a matter to which practical men always pay the closest and most anxious attention. But economists have not analyzed it carefully and have been content, as a rule, to discuss it in general terms….There is, however, not much to be said about the state of confidence a priori. Our conclusions must be mainly depend upon the actual observation of markets and business psychology. This is the reason why the ensuing digression is on a different level of abstraction from most of this book.”

The practical reasons for having confidence are surely the elements of intention, competence and reliability. What does it mean to have confidence in government, particularly the competence and reliability of Fed policy? In a 12/21/18 CNBC interview, John Williams, president of the New York Fed, crucially remarked:

1)    The Fed seeks the best policy, to achieve its dual mandate of high employment and low inflation.

2)    In developing this policy, it looks at the incoming data and, most crucially, talks to many others.

3)    As a result, the Fed “judges” rather than “expects.”

The underlined words are the crucial elements of rationality under the condition of uncertainty. (Hopefully) with our readers, we now discuss what rationality is.

The most general definition of rationality is to do things for reasons, to obtain a given result. A more specific definition of rationality depends upon the conditions under which it occurs. Ref. (Russell and Norvig, 2010). For instance, when driving to a destination, a fog might roll in. Depending upon the degree of fog, one can look at different things to reach one’s goal.

1)    On a clear day, there are no other vehicles, the environment’s landmarks are clearly visible; and one can drive along the best route with almost no other feedback. This is navigating under certainty. 

2)    The fog begins to roll in, there are no other vehicles, the environment’s landmarks are visible only in blurry outline; the prudent thing to do is to slow down and to verify that the landmarks are the actual ones. This is navigating under risk, when the alternatives are known but the probabilities of their realizations can be identified estimated * by numbers ranging from 0 to 1. The action to take is to proceed along the best expected route.

3)    The fog becomes pea-soup thick, there are no other vehicles, the landmarks appear sporadically, the smart thing to do is to slow down more and to ask the expert passengers to help identify the landmarks. This is navigating under uncertainty, where the alternatives must be identified anew in a complex world. Under these conditions, taking the best route requires good judgment, consultation with other experts and continued communication in a “multi-agent environment.”

This discussion shows that Reason can be a very powerful tool – when reasonably used after considering conditions.


* This is a very crucial distinction. In the practical world, good judgment is really important. Russell and Norvig (2010) write, “The connection between toothaches and cavities is just not a logical consequence in either direction. This is typical of the medical domain as well as most other judgmental domains: law, business, design, automobile repair, gardening…” The title of their definitive book is, “Artificial Intelligence.” It discusses A.I. algorithms and design considerations, also philosophy from Aristotle to Gödel, in 1132 quite difficult pages.

What is useful to us is that computer programming forces clarity upon some questions that originate in the humanities; A.I. is likely to have a very large impact on society. However, this is not at all to reduce one field to another.


At the 1/4/19 annual American Economic Association meeting in Atlanta, Fed Chair Powell and former Fed Chairs Yellen and Bernanke placed the implementation of Fed policy in the perspectives of the U.S. and world economies.

1.     Powell: The Fed will be patient and flexible in its implementation of monetary policy. The U.S. economy is growing moderately and well. In December jobs increased by 312,000 (our note: about 170,000 is normal), unemployment has been less than 4% for four months, wages are moving up along with labor participation.


The financial markets, however, foresee the opposite. With China pulling back, copper down. The financial markets are pricing in downside risk to global growth. We don’t have a fixed monetary policy. In the 2016 (international) taper tantrum, Chair Yellen nimbly adjusted rates and normalization resumed. We will be prepared to adjust policy quickly and flexibly.


We need the concept of the natural rate of unemployment, to give us an idea of whether interest rates are too high, too low or just right. The exact level of the natural rate is uncertain, but it is possible to go too fast in relation to resource constraints.


Future research ought to integrate macroeconomics (our note: assumes equilibrium) and markets (our note: assumes disequilibrium on the path to equilibrium ).


2.     Yellen: We have a strong economy with consumer spending comprising 2/3 of it. The Philips curve (linking unemployment and inflation) is relatively flat, giving the Fed the opportunity to move carefully in a data dependent manner, managing risk. The growth rate of the economy is consistent with potential and may warrant some tightening.


When giving rate guidance, it will be important for the Fed to co-ordinate across asset classes.


3.     Bernanke: It was very important for the Fed to anchor inflation expectations at 2%. As a result the Philips curve is flat, allowing the Fed to experiment with policy. Unanchored inflationary expectations mean that it is more difficult to stabilize the economy.


(This is really important because it provides an order that enables a rational and more deliberate management of the economy.)