Dynamic concept Monetary policy

Fed policy making – a PID insight

PID is the most common and simple control strategy in process control. Control decisions are based on the deviations (called error) between the target and the feedback from the parameter to be controlled. The error can contain information about its past, present and future. Mathematically they are represented by integral of the error, present value of the error, and the derivative of the error, respectively. The PID (proportion, integral and derivation) algorithm is to apply gains on these three elements. If the designer weighs more on the present value, he would apply heavier weigh on “P”; if weighs more on the historical information, he would apply higher “I” in the formula. Note the stability and better performance of the control system require PID settings within a certain range and the designer needs to optimize the PID setting within that range.

I think the Fed has recently relied heavily on present values in policy making. The Fed has attempted to hike interest rate, citing good job creations in the last few years; however, suddenly changed its mind based on a single job number. The latest case was the dismal job creation number in May, a single data prompted that the June or July rate hike is off the table. Ideally the Fed policy making should be more forward looking, i.e. heavier gain should be applied to the “D” portion in the PID strategy. This is because the economic dynamics have large time delay in responding monetary policies, a forward looking policy can compensate the delay in the economic dynamics. However the Fed is limited in relying more on “D” for the following two reasons.

First, the economic data collected have too much uncertainties. This is true especially in predicting future economic data. In May, economists were predicting 158,000 job addition, but only 38,000 jobs were created in May.

Second, the market responses often are short term, and presently the Fed policy making has taken too much financial market into considerations.

I think the Fed should improve the accuracies in its economic predictions and regain the confidence in making policies and thus pay less attention to market responses. In economic system, like any another control system, only one central controller is allowed, other wise the system could be unstable as several control systems can fight with each other.