Thursday, September 14, 2006

Fed Tells Berry That It Wants To Tell Us More.......Or Less

Odd logic this is, for the Fed to go through one of its journalists to let us know that they want to "cast more light on the central bank's inner workings". They could've just told us directly, but I guess old habits are hard to break.

The article written by John Berry, on Bloomberg News on Thursday Sep 14, starts out with:

Federal Reserve officials want to cast more light on the central bank's inner workings to give the public a better understanding of what they are doing and why. The big hurdle is figuring out how to go about it.

The article goes on to tell us:

The most important consideration, according to the minutes, was how to convey the FOMC's goals and Fed appraisals of where the economy is headed.
Fed Chairman Ben S. Bernanke has some ideas about how to lift the veil a bit more: He wants the committee to adopt a formal inflation goal and publish more frequent economic forecasts that would show the expected path for inflation.

This isn't about clarity, this is about keeping everyone's eyes on the horizon instead of their driving. They can ask us to do that because they have us convinced that they are the designated driver of choice.

As for what horizon we are driving towards, the article offers this (bold is mine):

More recently, the committee has indicated a willingness to take as long as two years to bring core inflation back down to 2 percent from the 2.4 percent increase for the 12 months ended in July.

This is all about about inflation targetting. An idea that, like many in economics, is wonderful in theory but somewhat problematic in the real world. Everyone understands that a low, stable, and predictable inflation rate induces business confidence to invest which, in turn, raises employment levels (the other one of the Fed's dual goals). This logic, right or wrong, is required because one policy lever can only work on one policy objective. Since the Fed works through the financial side of the economy, inflation has to be the target.

Take a look at growth, inflation, and the funds rate:

It easy to see that in the mid 90s similar real growth created far less inflation than we have today. Then, the Federal funds rate was significantly higher on its own and in relation to nominal GDP growth (add GDP and deflator). One could conclude that there is an overhang of monetary expansion still in the system since it was only this year that the funds rate got to the mid 90s level. Yet Fed officials talk about the tightening in the pipeline, as if rates have risen to some confiscatory level. My guess is that they are really talking about engineering a soft landing for housing now that the housing industry's rate subsidy is gone.

But the end of a subsidy doesn't mean rates are too high. There is nothing about the level of rates today to suggest anything other than that rates have, after two years, finally reached neutral. When did the economy become so rate sensitive that this level of rates risks recession? The market, in its infinite wisom, seems to think so. I think otherwise.

As for inflation and setting a target, the higher inflation today suggests a higher funds rate than prevailed in the mid 90s. Or, perhaps the funds rate was too high in the 90s, hence the idea that a 5+% rate will bring down current inflation. Or perhaps the answer is that the good inflation data of the 90s reflected the pace of growth of the G-10 nations -- most notably Japan. Those growth levels, lower then than now, directly effected commodity prices, namely oil. Therefore, then the Fed could afford to allow the economy to run at full steam without raising rates. The upshot is how do you pick a relevant inflation rate to target. Economics is one thing, policy is another.


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