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December 11, 2006
Forecasting the Fed is only as easy as forecasting inflation
That is to say, it's easy over very short time horizons and almost impossible over longer horizons. In Monday's Wall Street Journal, E.S. Browning continues the chronicle of the widening disconnect between the Fed and the market.
The Fed is expected to leave target interest rates unchanged, fueling hopes that it will start cutting rates some time next year, which would be good news for stocks and bonds.
But worries are spreading that, longer-term, investor hopes for interest rates may have gotten a little out of hand. If so, stocks and bonds both could be in for some rough waters in the coming months.
Later in the article, his interview subject expresses thoughts that should be familiar to any reader of this blog.
"Inflation is the key here," says Ethan Harris, chief U.S. economist at Lehman Brothers. "Inflation is the enemy of all markets. If you get serious inflation, if the Fed's fears materialize, then you will have the Fed hiking instead of cutting, pushing growth weaker. That is a lousy environment for both" the stock and bond markets.
Mr. Harris isn't forecasting a resurgence in inflation. He thinks it could remain more or less steady.
But, like the Fed, he doesn't think that is a sure thing, and he thinks investors could be making a mistake to assume that inflation is dying....
Sorry. No "one armed economists" here. On the one hand inflation could be under control. On the other hand the battle may not yet be over.
Some people find a certain irony in all this.
Now, Mr. [Jim] Bianco [of Bianco Research in Chicago] notes, "the guy that is holding the Fed back from easing is Helicopter Ben. We got him all wrong, at least for his first 10 months" in office.
It is really hard not to say, "I told you so."
Anyway, while we sit here and think about the implications of what the Fed may or may not do, Ed Prescott reminds us in a Wall Street Journal op-ed today that it may not matter all that much. The op-ed is titled "Five Macroeconomic Myths" and is sure to provoke a response from people who, for example, think that the national debt is too large (it's #4 on his list). Read the whole thing. Here's part of myth #1 that monetary policy causes booms and busts.
Between 1975 and 1980, the inflation-corrected federal funds rate was low; at the same time, output trended upward until late 1978. So far, things look somewhat promising for the mythmakers. But looking closer at the data we see that output began its downward trend in late 1979 while monetary policy was still easy through most of 1980. Also, output continued its decline through 1982, when it began to climb at a time when monetary policy remained tight.
These facts do not square with conventional wisdom. Our obsession with monetary policy in the conduct of the real economy is misplaced.
Where monetary policy's effect on output is concerned, expectations matter. That is a fact which is not lost on Mr. Bernanke, especially these days.
Posted by William Polley at December 11, 2006 01:16 AM
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