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Fed's 'Transparency Trap': Do We Really Want to Know Exactly What Bernanke Thinks?


Analysts have a natural tendency to take current conditions and project them forward, however gloomy those projections might be. And however little others want to hear them.

Editor's note: This article was originally published on January 28.

This week we take a brief pause in our series on the choices facing the developed world to look at some items that are catching my attention. We will get back to the US next week, as somehow I think we will not solve our problems between now and next Friday, and there will be plenty left for us to talk about. So today we look at the "shift" in Federal Reserve policy, and at the balance sheets of central banks, US GDP, Portugal and the ECB, the LTRO policy, and yes, there's even a tidbit on Greece. Plenty of ground to cover, so with no "but first," let's get started.

The Transparency Trap

The Fed announced this week that it will keep rates low until 2014. Interest rates responded by getting even flatter. This policy change has caused a lot of negative press, for some good reasons, but I want to offer a somewhat different take on their motives.

Telling us that rates will stay low for another three years has a lot of negative implications. First, it says that the Fed does not expect a recovery of any significance during that time (more on this week's GDP numbers further on). Second, it tells any individual or business that there is no reason to hurry and borrow money to get lower rates. You can wait and see how things turn out before you decide to act.

Comstock Partners minced no words in their scathing criticism:

In our view the Fed's new policy is an act of desperation rather than something to celebrate. The FOMC has used all of its conventional weapons and a lot of unconventional ones and is essentially out of ammunition. The banking system is swimming in excess reserves that it is not using -- adding more won't make much of a difference. This is a classic liquidity trap where further easing will not be much help. The stock market strength assumes that the economy is getting stronger and that company earnings will remain at elevated levels. We think that this will not be the case, and that the market is subject to substantial downside risk.
I agree with their sentiments and conclusions, but I think the Fed is in more than a liquidity trap. For lack of a better term, let's coin one and call it a "transparency trap." The Fed and the Federal Open Market Committee do not create their policies in a vacuum. The individual members talk to business leaders at length every week, and their staffs are also seeking out opinions and reactions. While they may not talk to you and me, they are aware of the reactions to their positions. Let's take that as a given. These are not men and women who are easily pushed into a position. They get where they are by being able to forcefully take a position and push for their policies. We may not like their positions, but they put some thought and a lot of work into making them. Frankly, it is a damn hard job. No matter what they do, they will make a lot of people upset. And this week is a case in point.

Fed Chairman Ben Bernanke has been quite open in that he wanted a more transparent Fed. He wanted explicit inflation targets long before he joined the Fed. He wanted more communication and openness from the FOMC. Many in the media and elsewhere lauded those sentiments, including me, as the more we know about their thought process, the better we can all plan.

However, there were others who said that the Fed needed to keep theirs cards closer to their chests. Showing too much of their inner reasoning could mislead as well, as policies could change and the Fed should not feel locked into any one position if the underlying circumstances shifted. There should be an element of mystery, they maintained. Some former members of the Fed were very outspoken in their desire to not increase the transparency of the Fed. As with sausages and laws, we simply do not want to know too much about what goes into making Fed policy, they asserted.

But slowly, Bernanke has put his stamp on the Fed, including his views on transparency. His speeches and presentations are far more comprehensible than the foggy pronouncements of former Chairman Alan Greenspan. He has started doing press conferences. And with this meeting, he has persuaded the 17 members of the FOMC to offer projections about the economy -- in this case, where they think rates will be for five years into the future.

The headlines talked about the Fed keeping rates flat into 2014, but if you look at their median forecast, they expect rates to rise by all of 0.5% at some point in 2014. And for the record, here are the rest of their more significant forecasts:

The Fed knocked down its forecast of economic growth a few notches for the entire forecast period (see table below). The Fed sees the economy growing around 2.2%-2.7% in 2012. The Blue Chip consensus forecast of growth in the US is 2.2% on an annual average basis as of January 2012, while the IMF projects growth of 1.5% for the United States in 2012 on a fourth quarter to fourth quarter basis.

The central tendency of the unemployment rate for 2012-2014 was lowered but the longer run projection was left intact. The unemployment rate is expected to be around 8.2% to 8.5% by the end of the year, which is different from the Blue Chip consensus of 8.5% (determined by a survey taken prior to the publication of the December employment report, most likely to be revised down). Inflation is projected to below the Fed's target of 2.0% until 2014. With regard to inflation, Bernanke formally indicated that 2.0% inflation is the Fed's target rate and this rate as being consistent with the Fed's dual mandate. (Asha Bangalore, Northern Trust)
All in all, not a very upbeat group. Given their views, it is no wonder they expect rates to stay low. And thus we have the transparency trap. They are now telling us what they really think, something that most people in most places wanted only a short while ago. And we see the 17 individual forecasts, so we can get a sense of the range of opinion, which is quite wide, actually. Look at the following graph, which shows us when the members of the FOMC expect rates to finally begin to inch up.

Note that six members expect rates to rise within the next two years and four expect rates to be flat into 2015, with two members thinking rates will not rise until 2016. And over whatever they define as the "longer term," they expect the Fed Funds rate to be 4.25%. (Which causes me to mangle that song from the children's movie classic, Snow White: "Some Day My Price Will Come.")

(You can see all the projections in glorious detail here.)

Tell Us What You Think We Want to Hear

If we want to know what they think, and they tell us, are we then going to shoot the messenger? We asked, they delivered. If they gave us those projections and did not change their interest-rate projections from the last meetings, they would be subject to ridicule because they did not say in the statement what they really believed.

In a very real way, they were forced to say they expected rates to be flat for two to three years. To say anything else would have been rather pointless, at best, and subject to even more intense criticism at worst. Once they opted for transparency, they were forced to take the position they did. Put this in the category of "be careful what you ask for, because you may get it."

Now, take note. And I do not mean this as a specific indictment of Fed economists and forecasters. This goes for all of us who dare venture a thought about the future.

There is a natural tendency to take current conditions and project them forward. Which is why stock analysts who forecast earnings are so predictably bad. And the all-star team of blue chip economists (in the US) have yet to predict a recession, even when one has started, let alone in advance! Once you rely on models, you are doomed to error. I have read studies that show analysts are not even as accurate as one would expect from simple random selection.

I think we should take these Fed projections as more of a curiosity, for at least the next two years. In two years we will have 16 data points (eight meetings a year) that will show us some of the evolution of their thinking, and that will be very interesting.

For what it's worth, if someone had asked me, I would have said that rates will be flat for a very long time. We inhabit a deflationary, deleveraging reality. That suggests lower inflation. I have written at length why unemployment will be higher than we are comfortable with; it is just a product of the current environment and simple math. To see unemployment come down, we need to see growth in the 3.5% range, and our next topic will show us why we are not even close to that number.

A Very Soft GDP Number

GDP came in at 2.8% for the fourth quarter of 2011. That is a respectable headline number, given that the US economy only did 1.6% for the whole of last year. For those who look at this number as half full, I offer the following observations. First, examine GDP growth for the last few years. The fourth quarter has been much better than previous quarters, and then GDP dropped off again.

The 2.8% number is softer than it looks. Two-thirds of that growth (1.9%) was from inventory buildup (standard accounting practice says that growth in inventory increases GDP, while sales of inventory reduces it):

Real final sales (GDP less inventory changes) expanded at an anemic 0.8% annual pace in the fourth quarter, a sharp slowdown from the third quarter's healthy 3.2% rate. That paints a different picture from the apparent pickup in headline GDP growth from the third-quarter's 1.8% yearly rate. The difference reflects the shift to inventory building in the fourth quarter from a drawdown in the third quarter. (Barron's)

I suppose one could spin inventory growth as businesses being optimistic about future sales and building inventory, but given the weaker retail sales of late (in comparison to previous years) that is rather doubtful. And so all that really happened was a total reversal of inventory sales in the previous quarters. There will be a drawdown of inventories over the next few quarters, which will be a drag on future GDP numbers, much like the pattern we have seen the past few years.

Retail sales growth was not strong. And for the last year, 90%-plus of total retail sales has come from decreased savings, as the savings rate dropped from 4% to 2%. It will be hard to go much lower, so the "boost" we got last year from retail sales accounts for most of the year-over-year growth in GDP. If most of retails sales growth came from reduced savings, that suggests that retail sales will not offer much in the way of growth for the coming year. Just saying.

Further, when calculating real GDP, one subtracts inflation. The Fed prefers an inflation measure called Personal Consumption Expenditures (or PCE). It is essentially a measure of goods and services targeted toward individuals and consumed by individuals. The number you read in the various media is the Consumer Price Index (CPI). The CPI is inflexible, in that it's always the same basket of goods. PCE, on the other hand, is supposed to take into consideration the notion that if steak is too costly, we'll eat hamburger. The CPI is typically 0.3% to 0.5% higher than the PCE, which is convenient if you want the GDP number to look better.

The Fed changed to PCE in February of 2000. The change was buried in the footnotes of the annual Humphrey-Hawkins testimony by Greenspan. So the anemic growth of 1.9% for the last decade would have been even worse if we had used the previous measurement of inflation (CPI). Understand, there is an argument in favor of using PCE, as many academics argue that CPI actually overstates inflation. But there is also an argument to use CPI. It somewhat depends on what you want the final numbers to be.

Fast forward to today, and the year-over-year change of CPI was 2.5%, with the PCE only rising 1.7%. And last quarter was down sharply, to +0.04% on an annual basis. An anomaly of lower energy and commodity costs? Partially, for sure. So if their target rate of inflation is 2%, using PCE gives the Fed grounds for a looser monetary policy.

All in all, GDP was helped by numbers that are not likely to repeat. For a long time I have maintained that the US economy is in a Muddle Through range of around 2%. I remember when last year at this time we had estimates of 4% to 5% growth for 2011. I looked so bearish. Now, not so much, as 2% would have been better than what we got.

I think we will be lucky to Muddle Through again this year. Mind you, if it was not for a potential shock coming from a serious European crisis and real recession, the US should not slip into outright recession this year.

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