September 15, 2003

What Will the Fed Do Next?

Greg Ip writes: - Fed Is Unlikely to Change Rates, But Future Course Is Uncertain: The economy is strengthening and inflation has stopped falling, both welcome signs for the Federal Reserve, which is almost certain to leave its interest rates unchanged when it meets Tuesday. The more important question will be what, if anything, the Fed signals about the future direction of interest rates.

In May, the central bank said risks to economic growth were balanced but the risk of inflation falling too low outweighed the risk of rising inflation. The Fed repeated that message in June, when it cut its short-term rate target to a 45-year low of 1% from 1.25%, and in August, when it added that rates could stay low for a "considerable period." But since then, the economy has been surprisingly strong and inflation has shown signs of edging higher...

That's not quite right. Since then, the economy has been surprisingly strong and surprisingly weak: news about output growth has been surprisingly good; news about employment losses has been surprisingly bad; the wedge between them--productivity growth--appears to have grown larger.

Were I sitting on the FOMC, I would be more impressed by the employment than by the output news, and would be disposed to cut interest rates by yet another 25 basis points. But I'm not.

Posted by DeLong at September 15, 2003 12:57 AM | TrackBack


I have read elsewhere that .75% is something of a floor...below that, the effects of cuts are much smaller.

I'm wondering A) is that true? and B) If so, do you think that the current situation really requires that move now? It seems to me that the real risk is that the housing bubble bursts...and even with a cut to .75 or lower, I can't see the Fed being in a position to do much about it. It's not like mortgage rates can get much lower...sooner or later, the banks just aren't making any money...

Posted by: JoeF on September 15, 2003 12:36 AM

Isn't the political pressure to deal with unemployment first and inflation second? What if cheap borrowing means that companies are investing in technology that is replacing the number of workers? At some point in the future, a retrained work force can be put to new tasks. Would this exacerbate problems? With global capital, how can the Fed be sure that cheap moeny translates into more investment at home and not more investment in overseas competitors?

Given the underinvestment in our public K-12 schools does the US workforce still have a competitive advantage in education?

Posted by: bakho on September 15, 2003 06:31 AM

It strikes me that both the Journal's assessment of the economy and that of Dr. DeLong is focusing on their favorite indicator of economic health. While some might argue that this is necessary, I don't think that this is the case. There has been a growth of interest in the area of "diffusion indices" which are attempts to extract information on economic activity from groups of indicators. The idea behind this approach is that there is some factor common to all of the various economic activity indicators, and it is this common factor, or index, that is useful for predicting economic activity. James Stock and Mark Watson started work in this area when they published a couple of papers where they came up with pretty good forecasts of inflation. The problem is that their index is not published for those who don't have the time to replicate their methodology. A more accessible index is the Chicago Fed National Activity Index (CFNAI), published monthly by the Chicago Fed and available on their website. The index currently stands at -0.20, where 0.00 indicates that the economy is growing at its long-term trend rate. While this figure is better than in the first part of this year, it does NOT indicate that we are out of the recession (the Chicago Fed's heuristic is that the index would have to be +0.20 or better to indicate the end of the recession). And in no stretch of the imagination does this indicate any inflationary pressure. In my humble opinion, this method of assessing the economy's position in the business cycle is superior to using one or two indicators that may be subject to significant "noise" in their measurement.

Posted by: Ken K on September 15, 2003 07:20 AM

"Were I sitting on the FOMC, I would be more impressed by the employment than by the output news, and would be disposed to cut interest rates by yet another 25 basis points."

Is the idea here that the employment numbers make the output numbers seem unsustainable? Because you wouldn't be targeting employment and disposing of output (and prices) as a target ordinarily.

The wedge between employment and output seems to make Fed policy an even more complex game than it is ordinarily, and even then it is too complicated for mere mortals.

One thing to keep in mind is the abundance of liquidity around in the form of money market and savings deposits (despite a recent slowing). The issue seems to be how to influence the spending of this sidelined money, rather than influencing the size of the stock. Do it right and you have a recovery and no threat of another bubble.

But there are so many ways to screw this up...I'm just glad it isn't my job.$file/sta369.pdf

Posted by: Jim Harris on September 15, 2003 07:30 AM

"With global capital, how can the Fed be sure that cheap moeny translates into more investment at home and not more investment in overseas competitors?"

Bakho, normally I would say that the cheap money cheapens the dollar exchange rate, making it more expensive for the US to invest abroad and to import from abroad, and making it easier for foreigners to invest in the US and import American stuff.

But now the US is basically trying to stand up with China on its back because the currencies can't adjust. The result is we are reinflating China, which just released higher than expected inflation results and is having a boom in economic activity and money supply. Once the Fed causes a more severe inflation in China the link will break and the Fed should have an easier time controlling the US economy.

JoeF - The Fed first suggested that .75% was a floor because below that would hurt money funds, then shortly after they took it back and said they'll go to zero if they need to.

Posted by: snsterling on September 15, 2003 08:06 AM

Ken K.,

We've actually had a CFNAI style diffusion index to look at for quite some time - the index of leading economic indicators. For longer period than CFNAI and a shorter period than leaders, ECRI has been cranking out a ton of leading indices. The CFNAI is an attempt to discover whether a much larger number of input series gives a better prediction of outcomes (in this case, inflation) than do indices with smaller numbers of input series, like the leaders. Since the Conference Board got hold of leaders and spruced them up, they seem to me to be doing a slightly better job of short-term forecasting than the CFNAI. ECRI indices are also pretty impressive. Trouble is, it is not necessarily the 3-to-6 month window that is in doubt. Without knowing much about truly jobless expansions, it is not all that clear what the lag is between "failure to thrive" in the labor market and growth falling back below trend. Might it be longer than 6 months? Can labor fail to thrive for another 6 months if growth is at or above trend for the whole period. Dunno.

Posted by: K Harris on September 15, 2003 09:19 AM
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