How Sharknado Explains the Federal Reserve

There is a movie called Sharknado. It is a real movie. It is about sharks in a tornado. The killer sharks in the tornado fly around snatching up people who say things like "we just can't wait here for sharks to rain down on us." 

And it explains everything you need to know about the Federal Reserve nowadays.

Sharknado, the movie, might just be a dumb story about sharks. But Sharknado, the business, is a story about a cable channel's need to keep upping the ante to persuade viewers that it can always come up with a crazier idea than the last. After all, this isn't the SyFy Channel's first foray into absurdist animal action. Before tornadoes started catapulting great white sharks at unsuspecting victims, there was Sharktopus and Dinoshark and Piranhaconda. But with each stoner nightmare of science-or-nature-gone-wrong, SyFy has had to turn the ridiculousness to 11 to keep anybody's attention: Alright, you've seen a genetically-engineered shark-human hybrid go on a rampage, but what about a genetically-engineered supergator ... versus, um, a a dinocroc!?! (Those are real movies by the way).

Upping the ante isn't just the job of the people in charge of SyFy Channel movies. It's also the job of the people in charge of the U.S. economy. Namely, the Federal Reserve.

For the last five years, the Fed has been in the business of persuading investors that it can be irresponsible. Now, in normal times, the Fed is anything but; it's boring. It just raises short-term interest rates when the economy is too hot, and lowers them when it's too cold. But when short-term interest rates are at zero, the economy is stuck in what economists call a liquidity trap. The Fed can't really cut interest rates below zero, because if it did, people would move their money from bank deposits that were costing them to cash that weren't. The only way the Fed can get the economy moving again is to cut real interest rates by, as Paul Krugman originally put it, credibly promising to be irresponsible.The Fed has to say it will run looser policy than it should in the future to raise expected inflation now -- and markets have to believe it won't go back on this.

In other words, the Fed has to promise to be a little, well, crazy. But the thing about crazy is that once you've been Sharknado crazy, you need to be even crazier to stay ahead of the curve -- or else disappoint everyone.

Of course, it's not easy for the Fed to even make investors think it's Dinoshark crazy. But after years of steady experimentation, the Fed has settled on a two-pronged strategy to do so -- and more. It has promised not to raise rates before unemployment falls to 6.5 percent or inflation rises to 2.5 percent, and it is buying $85 billion of bonds a month until the labor market improves "substantially"; the former is called forward guidance, and the latter quantitative easing. Now, the Fed likes to think that these two prongs work differently, but that's not at all clear. According to the Fed, forward guidance works by changing what people think -- the so-called expectations channel -- and quantitative easing works by changing what people own -- the portfolio channel -- in terms of stocks and bonds and other assets. But, as Mike Woodford has shown, it's possible that quantitative easing mostly works, because markets interpret it as a kind of forward guidance. In other words, a Fed that is buying long-term bonds is a Fed that looks less like it will raise short-term interest rates anytime soon.

If quantitative easing is really forward guidance, then less quantitative easing is tightening. Indeed, tightening is precisely what has happened since Bernanke started talking about "tapering" the Fed's monthly bond purchases back in May: real interest rates have shot up, even as inflation and inflation expectations have fallen, as you can see in the chart below from Brad DeLong.