A Fed That Has No Clue
Where are we in the economic cycle? To find out, Forward Editor Steven B. Weiner and Managing Editor Elizabeth Ecker talked with Lakshman Achuthan, cofounder and COO of ECRI, the Economic Cycle Research Institute. ECRI's record of accuracy in calling cycle turns is unmatched in the world of economics.
Here's what he had to say:
“Economists want what they do to be thought of as a science. You see this with the Nobel Prize for the 'ecoÂnomic sciences.' It's not really a science prize, but they try to get in the same room with the real scientists.
“So there's a false sense of precision all over the ecoÂnomic map. Almost all economic forecasters use models. Conceptually, what happens with most models is that they add things up. They say that 'if spending is this, and taxes are that, and interest rates are this, and oil is that, then the economy must do X; it adds up to that.' The problem is that the economy is wildly complex because it has this huge psychological component, which is us—people—and we're hard to fit in a model.
“The models can be useful between turning points, when the economy is locked into an uptrend or downtrend. But when you hit a cyclical turning point, the trend has broken. That's why there are these Wile E. Coyote moments for economists at turning points in the economy; Wile E. Coyote chases the Road Runner, misses a sharp turn and runs right over the edge of the cliff. Whatever their ideology, economists are all taught the same thing about model building. They use the same basic tool kit. A 63-country International Monetary Fund study of recession forecasting concluded that the record of failure to forecast recesÂsions is virtually unblemished. Economists everywhere around the world don't do well at forecasting economic turning points. They conclude that recessions are not forecastable; that they are the results of shocks, such as 9-11.
“In reaching this conclusion, they are wrong again.
“My organization, the Economic Cycle Research Institute, or ECRI, was founded by the business cycle scholar Geoffrey H. Moore. He, like his mentors Wesley C. Mitchell and Arthur F. Burns before him, believed that by objective analysis of an extremely detailed range of economic data, it should be possible to derive a list of valid indicators—what we now call leading economic indicators—that usually are predictive of the economy's direction. Now, after a century of business cycle research, including ongoing analysis of the major economies of the world, we at ECRI have demonÂstrated that we can identify economic turning points with a very high degree of confidence.
“How accurate have our predictions of recession and recovery been? In the last 10 years, we basically called oncoming recessions and recoveries four times correctly. If, over the past 10 years, when we said recession, you had left the stock market and moved into cash, and when we said recovery, you reÂentered the market and bought the S&P, your $100 in September 2000 would be worth $165 today. On the other hand, if you put $100 into the S&P in 2000 and left it there, it would be worth $79 today. I guarantee you that we have been lucky at times, but luck doesn't explain everything in terms of our forecasting record.
“Alan Greenspan, the former chairman of the Federal Reserve Bank, was a student of Geoffrey Moore. He is a good example of a policymaker who followed the leading indicators closely. He valued Moore's rigorous, data-based approach. He used it, and it worked out reasonably well when he did. There is at least one example of the Fed being ahead of the curve in the mid-1990s.
“Remember, monetary policy works with long and variable lags. If that is the hand you're playing with, you really have to be lookÂing out the windshield and not in the rear view windshield and not in the rear view mirror. If you look at the Fed in the last few years, they're been disastrously behind the curve
“In 2003, for example, the leading indicators were pointing to a revival in growth and no deflation. However, the Fed was cutting interest rates because they were afraid of deflation and a relapse into recession. Yet, in the third quarter of 2003, GDP growth went to a 20-year high. So I'm not saying that the Fed was responsible for the housing bubble, but low interest rates were one ingredient.
“When you're behind the curve with monetary policy, what you end up doing is introducing more instability into the business cycle; more booms and busts. And that's what you had. You had a boom in housing, then a bust. More recently, six months inside of the recession in June 2008, the Fed was leading the market to believe that they were going to raise interest rates from 2% to 3% by year-end. So at the time, the Fed funds futures were pricing in between three and four quarter-Âpoint rate hikes by December of '08. That's half a year inside a recession.
“I submit that the Fed was behind the curve. The European Central Bank was worse because it went a step further and in July 2008 actually raised interest rates inside a recession.
“At the end of 2009, and in early 2010, if you look at the weekly leading index growth rate, it peaks in the fourth quarter of '09 and turns down. By early 2010, I was tellÂing the world that there's a slowdown in the economy ahead. What does the Fed want to talk about? Exit strategy. Now, looking at the same measures, we at ECRI are sayÂing there's no double-dip recession, there's no deflation, there's a revival in growth ahead. Which way is the Fed looking? They're looking the other way.
“I believe (Fed Chairman Ben) Bernanke when he says that he has the tools to take back the stimulus measures in 15 minutes.' But I'm equally convinced that they have no clue when is the right time to do it. The fear I have is that our future inflation indicators will get some traction and move up dramatically. And the Fed will still have its foot on the gas
“What I'm describing, then, is a more unstable economy. It will have more booms and busts, more recessions in the coming decade. One key ingredient in that thesis is that there will be more volatility in the business cycle. The Fed is one way that we get there. The other big challenge is that unemployment won't have a chance to recover before the next recession. It takes very long expansions to resolve the long-term unemployment challenge.
“Another factor is interest rates. When interest rates move, the deficit discussion gets hotter. Today, we're having the deficit discussion with record low interest rates. I suggest that policymakers will remain behind the curve, with more and bigger swings in the cycles. We don't pro pose to tell you a precise forecast of what the quarter will look like a year from now. But we can tell you that in the months leading up to the next turn in the economic cycle, the consensus of economic forecasters will be dead wrong once again.
And that's the really critical time for decision makers— in both industry and government. It's the Wile E. Coyote moment. If you can't stay on the road, then the rest of it doesn't really matter.”