INSIGHTS

FED POLICY AND "THE LOGIC OF FAILURE"

Ed Peters
|
March 23, 2022

One of my favorite books is a small volume titled The Logic of Failure by Dietrich Dorner (Persus Books, 1997). Dorner studied decision-making under conditions of uncertainty, but he also placed his subjects under time constraints. That is, he constructed a dynamic simulation where the process continued to evolve as the subjects make decisions.

In one simulation, the subject runs an ice cream store where the connection between the thermostat and the refrigeration system has broken down. It will be some time before a repair person arrives, so the subject has to manually adjust the rheostat to maintain the right temperature for the ice cream. But there is a problem. The rheostat is not a thermometer. It is just a dial with numbers from zero to 100. Moving the dial changes the level of refrigeration, but the subject has to read the thermostat to see the resulting temperature. When there was a direct reaction between the rheostat and the temperature, most did fine.

But then Dorner added another twist: a time delay between the rheostat adjustment and the resulting temperature. This extra bit of uncertainty changed behavior dramatically. Most, seeing no immediate change, continually moved the dial if the temperature was rising. But then, the temperature would plunge because they moved the dial too fast and too far. So they would reverse course and start moving the dial the other way in the same manner. This reactionary process resulted in great fluctuations in the temperature, and it never settled.

The subjects who were successful moved the dial and then waited. If the temperature continued to move against them they moved it again and waited. If the temperature accelerated, they started to accelerate their dial changes. These subjects were more likely to maintain a stable temperature.

The Fed and other central banks face a similar problem. When they raise or cut rates, there is a lag between their decision and the resulting impact on the economy and inflation. If they are too reactive, then, like the majority of Dorner’s subjects, they will cause large fluctuations in the economy. But they also may have to speed up the process with larger rate changes if necessary. This is a delicate balancing act. Action is important, but patience is just as crucial. We’ll see which approach central bankers take this time.

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