Mixed economic signals are making it difficult for the Federal Open Market Committee to decide whether to decrease or increase the money supply, which in turn influences whether interest rates go up or down.
Let me make an analogy with my hobby of train watching. I know that locomotives manufactured by the Electro-Motive Division of General Motors use two-cycle engines — like a chainsaw or weed-whacker. General Electric locomotives use four-cycle engines, like most cars. If I hear a high-frequency exhaust beat from one of the 60 trains a day that passes through my neighborhood, I know it is probably an EMD. A lower frequency tells me GE. But if one of each is pulling the same train, I cannot tell what is going on.
When Federal Reserve officials see obvious signs of a recession, their decision is clear. They should increase the money supply so as to lower interest rates, which supposedly will stimulate the economy and buffer increases in unemployment.
Inflation, or increases in the general price level, tells the FOMC to contract the money supply. Less money in circulation stifles inflation, but it also raises interest rates, which is not popular.
Most Fed decision-makers have followed the economy for years. Toss them an economic indicator — housing starts, consumer sentiment or the statistical discrepancy line in the balance of payments — and they can tell you what it means for the U.S. economy.
They know how each data series is tabulated, by whom and how often. They know how these indicators fluctuated during past business cycles. Moreover, they also can explain exactly what implications each indicator has for monetary policy.
Such expertise is invaluable, but doesn’t turn policy-making into child’s play. Understanding many different economic yardsticks — each taken in isolation — requires education and experience. Weighing many such indicators together and reaching a useful conclusion about the overall effects is much harder.
Sometimes, all the signals point in the same direction. In 2001-2002, there were many indications that the economy had slowed. Unemployment was up and output was stagnant. There were few signs of inflation. Increasing the money supply to push down interest rates clearly was correct. As the economy strengthened into 2004, rates clearly needed to rise again.
Right now, signals are mixed. There are signs of inflation such as rising overall prices for consumer goods, gold and most commodities. At the same time there are indicators of economic slowing. Some surveys show consumer confidence is slipping. Housing is cooling and construction tapering. Some see consumer spending losing steam.
The danger is not unambiguous inflation or a clear recession. It is rather a return to the “stagflation” of the 1970s, when prices rose even as output and employment sagged. The FOMC is going to be criticized during the next year regardless of what members decide.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.