Managing risk is all about creating certainty.
When what we want to be certain about is highly complex but gets represented by a single number, it is easy to lose track of the nuances and even the facts.
Read more about it below.
During their colonial rule of India, the Brits were keen to get rid of dangerous snakes (who wouldn’t be?!?) and thus paid a reward for every dead cobra, which then led people to breed more cobras to collect the money. After the country’s independence, the problem became even bigger because the rewards stopped and the surplus snakes were released into the wild.
And last week the new Fed chair, Kevin Warsh, brought up Goodhart’s Law as an example of how meeting a target does not necessarily solve the underlying problem it is meant to. Named after the British economist Charles Goodhart, the law states that When a measure becomes a target, it ceases to be a good measure, because there is a tendency to focus more on the number (dead snake reward) and not on what it signifies (fewer snakes overall, please!), and therefore the two become disconnected or even detrimental.
Warsh made the comment that just because the change in personal consumption expenditure (PCE)—the Fed’s preferred inflation target—is measured at 2 per cent, it doesn’t necessarily mean that prices are stable, and (supposedly) if we get too stuck on the number itself, we risk missing the bigger picture.
That is especially true because, as mentioned last week, the Bureau of Economic Analysis is currently reworking the PCE methodology, a change expected to numerically lower the measure closer to the Federal Reserve’s target. However, that shift is not a sign that real-world inflation has calmed down, even if it technically provides a bit more wiggle room for interest rates.
From a broader risk perspective, it is worth remembering that metrics and numbers can only get us so far without explanation and context, and sometimes a narrow interpretation breeds more cobras.