The Fed is in the red

Research shows the US Fed doesn't get its predictions right as often as we would like to believe. With India and China in an upbeat mood, the dark days of last September are slowly fading in memory.

The present positive atmosphere is helped by forecasts continually being revised upward this year. Yet, there are many out there who are less optimistic about the future.

Guillermo Calvo, professor of economics at Columbia University, for instance, pointed out, in this newspaper, the possibility that while the economy may look up momentarily, in a year or two another crisis may well spring up.

Such an approach is usually termed 'conservative', markets are loathe to accept them and yet, by now we should have learnt how important it is to pay heed to the conservative view.

A recent paper* by researchers at George Washington University shows that even the Fed finds it difficult to predict the state of the economy one quarter ahead.

Their results - using data spanning more than thirty years - indicate that the Fed overestimates growth during recessions and underestimates it during recoveries and booms.

Similar results come in for inflation and employment. When the Fed had information about the state of the economy, appropriate revisions were made but the point remains that the state of the economy is only known to the Fed for the current quarter and is not incorporated in the quarter-ahead forecast.

Systematic errors do exist and may offset over the business cycle but 'given that knowledge about the state of the economy is important for setting monetary policy, the Fed's inability to forecast it one quarter ahead is disconcerting', concludes the paper.

While these results should help to temper exuberance, there is another pressing issue - our understanding of macroeconomics. A CEPR Policy Insight** by Axel Leijonhufvud focuses on the instabilities inherent in the current system and their implications for policy and regulation.

Much of the debate on the crisis has revolved on regulation of financial instruments, markets and to some extent institutions. But the centrepiece of this debate has been the assumption that the economy behaves as a stable general-equilibrium system, with problems arising due to frictions or market imperfections like moral hazard, informational asymmetries etc.

However, he categorically states, "this modern macroeconomics is wrong. If it were even roughly right, none of the desperate, improvised 'non-standard measures' by treasuries and central banks aimed at preventing unstable processes from overwhelming the markets would have been needed. …It is not to overcome 'frictions' that the authorities have been pouring trillions of dollars, pounds and euros into the world economy."

He points out three systemic problems that are potential sources of instability under current arrangements - the price level, the overall leverage in the financial system and the interconnectivity of financial institutions.

His recommendations may not be palatable, especially to the western financial big wheels -  re-instituting reserve requirements and extending them to cover all deposit-taking institutions, changing capital requirements in a counter-cyclical manner, breaking up or at the very least regulating big financial institutions that are active in "almost every market across the globe".

His paper has many interesting insights. For instance, to the usual list of social costs of the crisis he adds the cost of misallocation of resources during the boom times: "A lot of young talent was lured into the financial sector in those years. Society could have had better use of all that talent elsewhere."

Referring to the diversification and interconnectivity of institutions, markets and institutions, "we have let a situation develop where, from a macro-prudential standpoint, all the eggs have ended up in the same basket. At the present time, a lot of them are broken and more are cracked. We have on our hands one giant omelet that is not easily unscrambled."

And most importantly for the future: "The line between fiscal and monetary policy has all but disappeared in the welter of financial rescue measures…Seeing the Fed, in concert with the Treasury, coming to the rescue of an insurance company one of whose offshore branches has brought it to ruin, one realizes that central banking has changed beyond recognition."

He strikes a dire note for the need to regulate big financial institutions, despite their political clout: simply put, the fiscal situation of the major industrialised nations cannot cope with another financial collapse as this one.

We are all in this together, so let us pay attention to Calvo and others who stress caution, and not get carried away by upward revisions of forecasts or by misplaced hubris that the east will rise and take over.

*Can the Fed predict the state of the economy?' available at http://www.gwu.edu/~forcpgm/2009-001.pdf
**Curbing instability: policy and regulation', available at http://www.cepr.org/pubs/PolicyInsights/PolicyInsight36.pdf

Sumita Kale is Chief Economist at Indicus Analytics.