Business Times - 27 Nov 2007
Why read the Fed when it can't read the economy?
By LEON HADAR
IN a recent speech in Washington in which he stressed the efforts by the US central bank to become more open and transparent about monetary policy, Federal Reserve chairman Ben Bernanke acknowledged how difficult it would remain for him and his colleagues to make economic predictions. 'The only economic forecast in which I have complete confidence is that the economy will not evolve along the precise path implied by our projections,' he said.
That may sound like an exercise in self-deprecating humour. But it is clear that notwithstanding the commitment by Mr Bernanke to provide more information about the Fed's economic forecasts and deliberations about interest rate policy, deconstructing the Fed's thinking about the economy and predicting its interest-rate decisions would remain a Mission Impossible. One major reason why 'reading' the Fed would remain difficult is quite simple: Even under the perfect model of decision-making in which the Fed becomes more open, providing 'more-timely insight into the committee's outlook' and allowing businesses and households to make rational decisions, the marketplace will continue to offer us many surprises.
That being the case, it will make it difficult for the Fed to 'read' the economy - and in particular, to figure out the right balance of risk between inflation and growth - and make the anticipated rational decisions we expect from Mr Bernanke and his colleagues. Indeed, that sense of uncertainty and volatility that dominates the workings of the economy these days as the Fed is getting closer to making another critical decision on interests and which are reflected in the swings experienced by the financial markets, demonstrates the extent to which - as Yogi Berra, a former baseball player famous for his malapropisms, put it - 'It's tough to make predictions - especially about the future.'
And let's not forget other words of wisdom by the famous New York Yankees' catcher: 'The future ain't what it used to be.' In a way, only a few days ago, most analysts who were speculating about the future - the next Federal Open Market Committee (FOMC) meeting in early December - suggested that the members of the committee would probably not be open to the need to cut rates again. After its last meeting on Oct 30-31, the FOMC decided to cut the Fed's key interest rate to 4.5 per cent from 4.75 per cent. The statement issued by the Fed summarised the thinking of the FOMC members by indicating that the risks of weaker growth and higher inflation were balanced.
Since the meeting, many Fed watchers argued that most FOMC members were concerned over inflationary risks, triggered by rising energy costs and a weakening US dollar, and would be more inclined to back a neutral position and refrain from cutting rates again in December. But the minutes of the late-October FOMC meeting as well the Fed's new quarterly statement - reflecting its new economic forecasting system that is supposed to provide more insight into the central bank's thinking - seemed to have produced a revision in conventional wisdom in Washington, playing into the hands of investors in Wall Street who had hoped that the Fed would embrace another interest rate cut.
Anyone reading the minutes and the statement would have to conclude that both those who fear inflation (and argue against another interest rate cut) and those who are more concerned about the effect of the housing market crisis and the credit crunch on overall economic growth (and want more cuts) could project their respective wishful thinking into the FOMC deliberations.
On the one hand the minutes indicate that the decision to cut rates was a 'close call', that the risks to growth and inflation were 'roughly balanced' and that should be regarded as a 'significant valuable insurance against an unexpectedly severe weakening in economic activity'.
But at the same time, the minutes also highlighted a more cautious-than-expected consensus on the outlook for American economic growth than the country's financial markets expected, suggesting that the Fed is now actually more sensitive to the risks to the economy and more inclined to consider another rate cut in its next meeting.
When it comes to inflation worries, the Fed forecast notes that food and energy costs could put upward pressures on prices, but stresses that underlying inflations remain in the Fed's target range.
So with oil prices continuing to rise and the value of the US dollar continuing to fall but as the American economy continues to face recessionary threats in the form of the combined housing and credit crises and as companies are trying to measure consumer behaviour, those who are trying to predict the decision by the FOMC should recall another of Yogi Berra's sayings: 'If you don't know where you are going, you might wind up someplace else.'
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