TCS Daily


Clueless Fed

By Kevin Hassett - March 20, 2003 12:00 AM

Of all the policy announcements in the history of the Federal Reserve, Tuesday's was the weirdest. In addition to announcing interest rate policy, the Fed began several years back announcing its forward-looking policy bias as well. If, for example, the Fed were close to reducing interest rates, then it would announce that the risks leaned in the direction of economic weakness.

The bias statement this time was so unusual, it is worth quoting in full.

"In light of the unusually large uncertainties clouding the geopolitical situation in the short run and their apparent effects on economic decision making, the Committee does not believe it can usefully characterize the current balance of risks with respect to the prospects for its long-run goals of price stability and sustainable economic growth. Rather, the Committee decided to refrain from making that determination until some of those uncertainties abate. In the current circumstances, heightened surveillance is particularly informative."

In other words, "we don't have a clue."

Now the lack of a clue has not stopped the Fed in the past. They even raised the heck out of interest rates a little while ago, helping to hurl the economy into recession because of a faulty belief that higher stock prices would cause inflation to run amok. The difference this time is that the Fed doesn't have a clue, and it is willing to admit that it doesn't have a clue. So what's going on?

First, the economic times are very strange. Last year looked like a normal recovery, and then activity ground to a halt at the end of the year. The data for the first quarter of this year have been pretty terrible, suggesting that another recession may be underway. That sounds like "weakness" doesn't it? But, on the other hand, the anticipation of the war with Iraq has clearly had a big effect on the economy. First, as mentioned in this space last time, oil prices have skyrocketed until recently. Second, financial markets have been hit hard by the uncertainty. Thus, there is a clear identification problem. Is the economy in trouble because fundamentals are still weak, or is geopolitical uncertainty driving everything?

Undoubtedly, one of the unique properties of this recovery has been the absence of a financial market celebration. Uncertainty over Iraq clearly has played a roll in that. Indeed, the market likely has capitalized into current prices a positive probability that Iraq will go down shooting, firing missiles at every possible economic target in the Middle East. The human, economic and financial damages from such a move could be enormous. Economically the biggest target would be oil fields, refineries, and shipping lanes. In a worst case scenario, the world supply of oil would be cut off at the source, and the price of a barrel might double. We will discover whether this scenario occurs in the next couple of weeks. If it does not, and regime change in Iraq is underway with minimal disruptions, then the financial market celebration may be tremendous. How tremendous? The stock market calculator at Dismal.com, for example, currently says that the stock market is undervalued relative to historical relationships by about 50 percent. That is a lot of downside fear.

While there is certainly a great deal of slippage in such things, the likelihood, then, of a large positive swing in equity markets is significant. If that occurs, then one might expect sentiment, spending, and business fixed investment to follow the market up. A financial market celebration will make further Fed stimulus unnecessary. Judging from Mr. Greenspan's recent remarks, the Chairman clearly views this as the most likely scenario.

There are, of course, other scenarios. First, the worst could happen, and the human and economic devastation from the war could be greater than expected. In that case, the market will tank, and the economy may go with it. Another alternative, and probably the most likely, is that the U.S. wins in Iraq, but the market does not celebrate too much. In that case, one could judge that the market's perception is that the fundamentals of the economy are still very weak.

So we will learn a lot about our economic future in the next couple of weeks. Until we see the Iraq war and financial market response play, even the Fed doesn't know which way the economy is headed.
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