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Perhaps this article from the current issue of Businessweek will help
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JW
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BUSINESSWEEK ONLINE : MAY 29, 2000 ISSUE
ECONOMICS
Is the Fed Fighting a Phantom Menace?
A new study says no indicator is much good at predicting the inflation
rate
With unemployment at a 30-year low, it seemed only natural for the
Federal Reserve to raise interest rates on May 16. Conventional wisdom
says a tight labor market forces companies to pay more for scarce
labor, and this leads to higher prices. Unemployment is ''the classic
and most watched indicator'' of inflation, says Jonas D.M. Fisher,
senior economist at the Federal Reserve Bank of Chicago.
But a new study by the New York Fed throws cold water on this widely
accepted theory. It finds that inflation cannot be predicted from
current unemployment rates. Some 85% of the time, according to the
study, taking unemployment into account produces worse forecasts than
simply assuming inflation will continue on its current path. And
that's not all. Other widely followed indicators of inflation do
little better (table). This suggests the Fed's forecasting ability is
far weaker than many people believe--and there's at least a chance the
Fed is waging war against a phantom inflation menace.
The study, The Unreliability of Inflation Indicators, cannot be
dismissed lightly. Its three authors are Stephen G. Cecchetti, an Ohio
State University professor and longtime inflation hawk who is a former
research director of the New York Fed; Rita S. Chu, a New York
University graduate student who used to work at the Fed; and Charles
Steindel, a senior vice-president for research at the New York Fed.
The authors sized up the performance of 19 supposed indicators of
inflation from 1985 to 1998. These included measures of the real
economy, such as the unemployment rate; financial indicators, such as
interest rates; and commodity prices, such as the prices of gold and
oil. They found that none of these reliably improved on forecasts that
simply projected past inflation rates into the future.
GUESSWORK. Each measure had its own problems. For instance, average
hourly wages did a decent job of predicting inflation. But that's
because the researchers assumed unrealistically that a forecaster
using wages to predict inflation would have perfect foreknowledge of
the wage level for two years ahead. In reality, forecasters don't know
what wages will be any more than they know what inflation will be. In
fact, inflation affects wages, so the researchers' shortcut amounts to
knowing inflation in order to predict it. Write the authors:
''Forecasters need an indicator whose future values can be predicted
independently of inflation.''
Some other widely followed indicators don't have that interdependence
problem because they aren't influenced as much by inflation--but they
have their own drawbacks. Financial indicators, for example, tended to
be ''absolutely rotten,'' says David A. Wyss, chief economist at
Standard & Poor's DRI, a unit of Business Week'S publisher, The
McGraw-Hill Companies, who analyzed the Fed study. The poor
performance of M1, which is currency plus checking and savings
accounts, is particularly notable, Wyss adds, since monetarists
believe inflation comes from overly rapid growth in money-supply
measures such as M1.
As a group, commodity prices proved to be the best inflation
predictors--but in a way that defies all rationality. When the prices
of industrial materials, gold, and oil rose, inflation tended to fall.
One possibility the authors consider is that the Fed noticed the price
increases and reacted to them so strongly with higher interest rates
that its moves extinguished the inflation the commodity prices were
signaling. But they say the possibility that policymakers regularly
overreact to commodity price signals is "far-fetched."
Cecchetti, Chu, and Steindel note that their study concerns indicators
used individually, and they suggest it might be easier to forecast
inflation using combinations of indicators. James H. Stock of Harvard
University and Mark W. Watson of Princeton University, for instance,
have used historical inflation data to generate a predictor
incorporating more than 160 indicators. But it's still not clear that
the composite is consistently much better than single indicators.
''We're still in the research and development and testing phases,''
Stock says.
Another alternative to the single-indicator approach is to build a
complex, multi-equation model of the economy that spits out forecasts
for all kinds of measures, from inflation to gross domestic product.
Examples include the models of the Fed, DRI, and Macroeconomic
Advisers LLC in St. Louis.
Cecchetti and his colleagues find the DRI model, the only one they
examined, outperformed single-indicator forecasts nearly every time.
But that's not much use to the Fed, because the predictions of macro
models incorporate expectations of what the Fed itself will do. Before
intervening, the Fed needs to know how the economy would fare without
its actions. For the Fed to base decisions on this sort of model would
be like looking into a hall of mirrors.
If inflation is so hard to predict, what should the Fed do? Inflation
hawks argue that it's prudent to raise rates now so inflation doesn't
have a chance to take root. An alternative argument is that preemptive
interest-rate moves are unwarranted. There's a cost to inflation, but
there's also a cost to squelching a healthy economy.
By Charles J. Whalen in New York
---
Cracked Crystal Balls?
New research shows that many widely used inflation indicators perform
poorly. Here's how often they reduce the accuracy of forecasts
PERCENT OF TIME IT
INDICATOR REDUCES ACCURACY
M1 92%
UNEMPLOYMENT RATE 85
CAPACITY UTILIZATION 62
NAPM COMPOSITE INDEX 62
*Based on data from 1985 to 1998
DATA: CECCHETTI, CHU, & STEINDEL
---
Copyright 2000, by The McGraw-Hill Companies Inc. All rights reserved
-----Original Message-----
From: listmanager@xxxxxxxxxxxxxxx
[mailto:listmanager@xxxxxxxxxxxxxxx]On
Behalf Of Ronald McEwan
Sent: Wednesday, May 24, 2000 7:06 PM
To: realtraders@xxxxxxxxxxxxxxx
Subject: [RT] Gen:Chicken or Egg
What came first, the chicken or the egg?
Or in this case Inflation or a rising Money supply?
I took the following data sets:
Consumer Price Index for All Urban Consumers:
All Items
1982-84=100, Not Seasonally Adjusted
Source: U.S. Department of Labor, Bureau of Labor Statistics
M3 Money Stock
Not Seasonally Adjusted
Billions of Dollars
Source: H.6 Release -- Federal Reserve Board of Governors
I standardized the two series (subtracted the mean and divided by the
standard deviation) to scale the two data sets to each other.
So does the CPI rise coincidentally with the Money Supply or vice a
versa? Or is the inflation that AG is so concerned about due to his
own
action of over increasing the Money Supply?
Ron McEwan
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