Robust control, animal spirits, twilight zone risks

We have talked about being in the investment twilight zone where we are between the old regime of QE and the new regime of rate normalization. The Fed either does not know when to make the jump to the new regime or does not have the data to cause them to jump but the old regime is over. This creates market uncertainty that is a different form risk. The uncertainty is that we do not know the model of the markets that can fit the facts or behavior. We have been given Yellen dashboards and Taylor Rules, but the link between data, model, and action is not clear.  Our benchmark models of behavior could be flawed.

The flaws in models can be on two levels. One, the models used by the Fed itself could be wrong. Given their forecasting history, this is a real problem. Two, our view of what the Fed is doing could be flawed. We are using the wrong model to explain the Fed. There is uncertainty over what is the true model managing monetary policy. This requires deeper thinking about policy behavior.

The use of robust control can provide some important insights on the how investors may behave to this problem. It is nicely described by Rhys Bidder of the San Francisco Fed in "Animal Spirits and Business Cycles". The robust control work suggests that when there is a model problem that creates uncertainty the best approach is to develop a worst case scenario against a benchmark. Take a benchmark model, shock its parameters, and assume the worst. This is form of min-max thinking when the model used could be wrong. There has to be a trade-off of pain and plausibility. Start with something plausible and then see what happen to your pain if the model is not true. The robust control model gives a framework on what to do, but this has strong macro implications.

Your worst case scenario will be tied to the amount of volatility or uncertainty faced. If volatility increases, the worst case scenario approach will mean that your negative view will get worse. More uncertainty leads to more thinking of possibilities away from the benchmark. In the macro trading world, the markets will be more sensitive to volatility changes and disagreements about the benchmark. Call it animal spirits, but traders will be a knife's edge on Fed thinking changes even if they don't know the true model. Since we are in the twilight zone between policies, we are facing the maximum uncertainty and a pessimism based on worst cases.