There’s no canary in the coal mine to keel over, no fat lady to sing, no early warning system to signal imminent danger.
Yet somehow the Federal Reserve will know when the time is right to exit from what it calls “the current exceptionally accommodative stance of policy” to something a little less exceptional?
How, exactly? What will tell policy makers the era of easy money is over?
The Fed has econometric models that predict growth and inflation (they’re silent on asset bubbles). It relies on something called the output gap, or the difference between actual gross domestic product (hard to compute) and potential GDP (a moving target), to warn of inflation on the horizon. It monitors headline and core inflation (lagging indicators). It pays a lot of attention to inflation expectations as reflected in the spread between yields on nominal Treasuries and those indexed to inflation. And it keeps a close eye on wages, which are the biggest input cost for service-producing industries.
What it lacks is a track record that inspires confidence. For a group that refuses to acknowledge the key role monetary policy played in fueling the housing bubble (not to mention the Internet and tech-stock bubble before it), a group that advocates regulation, not preemption, as the cure, Fed officials want us to believe that this time they will get it right.
No one questions that the Fed has the tools it needs to raise interest rates and shrink its $2.5 trillion balance sheet. It’s as easy to sell Treasuries as buy them if you’re price insensitive. The issue is one of timing.
Timing Is Everything
With overall and core inflation below the central bank’s 2 percent ceiling, time is one thing the Fed thinks it has plenty of.
However, the demands of time and space travel argue for a modicum of prevention and preemption. No one knows what the “new normal” is for the neutral funds rate: the rate that will keep the economy growing at its potential in perpetuity. (Not to worry: No one knew what the old normal was either.) We know it’s not zero to 0.25 percent, which is where it’s been for more than two years.
The yield curve, or the spread between the Fed-controlled short rate and a market-determined long rate, is near its widest in four decades. The tinder is in place, just waiting for banks to capitalize on the yield differential.
So, how does the Fed know when it’s time to take the first baby steps to normalize interest rates? The Fed’s analysis of inflation is centered on two questionable concepts: inflation expectations and the output gap. Money rarely merits a mention.
The Fed regards inflation expectations as an independent variable, capable of producing inflation on their own. In other words, if we all expect higher prices tomorrow, we will buy more today and push prices up.
Nonsense, say Austrian economists. People can’t will prices higher. If the money supply doesn’t increase, the public can’t increase its expenditures regardless of anticipation of higher prices in the future. Only the central bank can create inflation, which it does when it accommodates our increased spending by passively providing the reserves (printing money) the banking system demands at any given overnight rate.
The output gap sounds great in theory. An economy can only produce what it can produce, given a limited supply of land, labor and capital. If there is more demand for goods and services than producers can deliver, prices rise to allocate the supply.
Mind the Gap
Makes perfect sense, right? The problem is, consumers don’t demand a unit of GDP. We want gasoline for our cars, cotton towels for our homes, medical care for our families and accountants for April 15. The macro economy is made up of thousands of micro-universes. Producers may have a backlog of widgets but a dearth of drilling machines.
Output gappers like to use the unemployment rate as a proxy for the degree of slack in the economy. In the last two months, the civilian unemployment rate plummeted from 9.8 percent to 9 percent. While payroll growth, derived from a separate survey of businesses, was tepid, history suggests such steep falls aren’t a drop in the bucket.
Large month-to-month declines in the unemployment rate are rare and “usually signal the start of a very strong upturn in growth,” says Joe Carson, director of economic research at AllianceBernstein in New York.
That was the case in 1954, 1958, 1961 and 1983, when big declines in the unemployment rate -- the result of either workers dropping out of the labor force or new hiring -- turned out to be the start of a trend, he says.
If full employment is the Fed’s goal, as well as its legal mandate (along with stable prices), policy makers still don’t know what that is (yes, there’s a new normal for full employment, too!) or when to start weaning the economy from ultra-low rates to orchestrate a smooth landing. Much of what the Fed relies on is the equivalent of shooting in the dark.
It’s this kind of stuff that makes former first lady Nancy Reagan’s reliance on astrology look sound.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)
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