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Beware Forecasters Who Are Certain They Are Right

Irwin M. Stelzer

Our economy is increasingly policy-driven, at least in the near- and medium-terms. What Congress and the president do or don’t do, what incoming Federal Reserve Board chairman Janet Yellen does or doesn’t do, will be important determinants of our growth, inflation, and job creation rates. So here is an attempt to see through the mist of obfuscation that is a feature of political and policy-making discourse, and spy the contours of future policy.

Start with the fact that the monetary policy gurus at the Federal Reserve Board have made it no secret that they would very much like to dismount the tiger that is QE3—asset purchases and money printing—without turning slow growth into no growth or a recession. The only question is when—sooner if some monetary policy committee members have their way, later if incoming chairman Janet Yellen prevails. Add a second fact: the belief by a majority of Fed policy makers that monetary policy works: (1) printing money keeps interest rates at or near zero, (2) zero interest rates in turn force investors to hunt for yield, which in turn (3) drives up asset prices (houses and shares), (4) creating a “wealth effect” that encourages spending by those fortunate enough to own homes and shares, (5) thereby promoting economic growth or at minimum preventing a recession.

Not everyone agrees that this five-step recovery program will produce sustainable, sober growth. After all, despite the fact that the Fed has been buying up assets and printing money at the impressive pace of $85 billion per month, the annual growth rate remains below 2 percent, and job creation, which averaged around 200,000 per month before the Fed began its asset-purchase program, is now averaging closer to 140,000. And if printing money could produce wealth, citizens from Argentina to Zimbabwe would be as rich as Croesus, rather than watching the value of their cash evaporate before they can get to the stores to spend it. Which is one reason that Richard Fisher, president of the Federal Reserve Bank of Dallas and due to become Yellen’s thorn-in-chief when he joins the monetary policy committee (technically, the Open Market Committee) in 2014, says there is a point at which printing money becomes an “agent of financial recklessness” … and worries because “none of us really knows where that tipping point is.” That admirable confession of uncertainty marks Fisher as a man to be listened to.

When the monetary policy committee meets in a few weeks’ time it will face this set of facts:

  • The economy is growing steadily but slowly, with such growth as there is fuelled by housing and auto sales, two sectors especially sensitive to increases in interest rates, which means that higher rates might have a significant impact on overall growth.
  • The unemployment rate has been falling, but in good measure only because so many workers have become too discouraged to continue looking for work. And many of the jobs being created are part-time only.
  • Inflation, which many Fed critics feared would heat up as the printing presses rolled, remains below the 2 percent rate the Fed considers desirable, and there is more talk of possible deflation and a Japan-style lost decade than of an inflationary spurt.
  • Policies that stifle growth seem to be preferred by our politicians. Fiscal policy is tightening as Republicans turn back President Obama’s demand for another round of stimulus spending on infrastructure, premiums paid by businesses and individuals for health insurance are rocketing skyward to discourage hiring as the provisions of Obamacare come into effect, and congress is preparing to allow benefits to the long-term unemployed expire.

From which one can conclude either that the Fed should run the presses even faster, or that the asset-buying, money-printing program known as QE3 should be wound down. Which brings us back to Yellen, and to the social values that always underlie economic policy-making. The incoming chairman would rather risk inflation and the distortions produced by zero interest rates than continued high unemployment. She has said that unemployment statistics “are not just statistics to me. Long-term unemployment is devastating to workers and their families. The toll is simply terrible on the mental and physical health of workers.” Laudable sentiments.

So it is no surprise that Yellen is reliably said to be unhappy with the current policy goal of withdrawing stimulus when the unemployment rate falls to 6.5 percent, preferring a target of 5.5 percent coupled with a reversal of the drop in the labor force participation rate. If that involves accepting a higher rate of inflation—4 percent is a number being bandied about, although not by Yellen—so be it. But she is a good enough economist to recognize the validity of some of the criticisms of QE3, and to know that printing money is not a goal in itself, but a means to an end: low or zero interest rates (after accounting for inflation).

Unfortunately for the chairman-to-be, outgoing chairman Ben Bernanke began musing in June about a “taper,” a gradual reduction in asset purchases. That caused a flight from the bond market, as investors scrambled to avoid the slide in bond prices that would drive up interest rates. Bernanke subsequently dropped taper talk, but investors had been reminded that Taper Day would come, late or soon, and are keeping long-term rates higher than the Fed would like them to be.

Yellen’s job will be to persuade her colleagues to put off any significant taper until the economic recovery is more robust and the job market has improved. But the evil or happy day (depending on your point of view) will come when QE3 must be slowed lest it hit the iceberg called rampant inflation. The Fed will try what in the jargon is called “forward guidance”—announcing that it will keep short-term rates at zero until its policy goals are met. And it can lower the rate it pays banks to keep funds on deposit, which deposits have massively increased since the Fed has been buying bonds from the banks as part of QE3. Presumably, that would give banks a greater incentive to reduce deposits at the Fed and instead lend more to consumers and businesses, with a positive effect on the growth rate. The effectiveness of such a move will depend in part on whether the banks respond by lending more, or make up for the lost interest by raising the rates they charge their customers.

The only sure thing is that there is no sure thing. Economic and policy forecasting are games in which one should follow the advice of Pulitzer Prize-winning columnist, Charles Krauthammer, who in his best-selling collection of essays advises “viewing certainty with suspicion.” Use that guideline to determine which forecasters to credit, and which to ignore.

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