The Oser View: May 2007

The Federal Open Market Committee, the Fed’s policy arm, kept the fed funds target at 5.25%, where it’s been since June 29, 2006. The statement explaining the decision was all but identical to the one issued at the last FOMC meeting six weeks ago:

“Core inflation remains somewhat elevated.”

“Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain these pressures.”

“The Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected.”

“Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth as implied by incoming information.”

The only change was an admission that “economic growth slowed in the first part of this year,” but obviously not enough to change minds or prompt action.

In short, the FOMC will not adjust the fed funds target—down or up—until it sees significant changes in core inflation and/or unemployment. A rate cut will probably require consumer inflation to drop below 2% with unemployment moving closer to 5%.

In any of the numerous books meant to explain modern physics to the educated layman, you will find a digression to discuss and then dismiss the Anthropic Principle. The principle is really more a paradox in logic than an actual scientific theory. It suggests that, far from being taken for granted, intelligent life in the Universe is the startling and all-but-impossible outcome of an extremely unlikely combination of chemical and physical properties. This observation has lead to speculation that since the Universe is so exactly right for us, we and the Universe must have some special, interactive connection, not necessarily in the spiritual sense, but in the physical sense. An axiom of quantum physics—the study of very small particles—holds that any observer, no matter how careful, inevitably distorts what he observes. The Anthropic Principle holds that the same is true on the vast scale of cosmology. Now, the reason the Anthropic Principle is so often treated like an unwelcome house guest, is that it is scientifically unverifiable. The only way to prove or disprove that our existence as observers somehow interferes with the Universe is to compare ours to some other Universe. While this can be done in thought experiments, it will probably be forever impossible in reality.

The relationship between observer and data evokes considerable philosophic, as well as scientific, interest. Nick Bostrom in Anthropic Bias (New York: Routledge, 2002), neatly sums up the broader problem, “There are selection effects that arise not from the limitations of some measuring device but from the fact that all observations require the existence of an appropriately positioned observer. Our data is filtered not only by limitations in our instrumentation but also by the precondition that somebody be there to “have” the data yielded by the instruments (and to build the instruments in the first place).” The filtering is one-sided in the hard sciences. A geologist’s ability to analyze a rock is circumscribed by her skills, her tools, by the constraints of being a carbon-based life form. But the rock is a rock. It is the thing observed. It cannot observe back.

The social sciences, of which economics is one, are different. Here, the data does observe back because the data is created by human actors in a dynamic world. The danger of Bostrom’s “Selection Effect” is consequently magnified. And when the data is not merely a count of something, the number of people working say, but opinions and particularly opinions about what may happen in the future, then the odds of reliable observation get long indeed.

Federal Reserve Governor Frederic Mishkin recently presented a paper called “Inflation Dynamics.” Speaking to an audience of macroeconomists, Mishkin asserted the paramount value of the general public’s inflation expectations. “The most important development in monetary economics that I have witnessed over my now-long career has been the recognition that expectations are central to our understanding of the behavior of the aggregate economy.”

We can substitute the word “observer” for Mishkin’s “witness” and put his conclusion in Selection Effect terms. The attempt by the observer to measure the data whose output is called the inflation rate is notoriously difficult. Inflation, after all, is the set of all human choices regarding the cost/benefit trade off of all goods and services. Not content with the daunting task of observing present inflation, Mishkin wishes to observe people’s expectations about inflation months and years in the future. His observations are “that the public’s expectations stood at a high level of 7-3/4 percent at the start of the 1980s, when this information first began to be collected. From that point on, however, expectations fell steadily over the 1980s and most of the 1990s.” This decline in inflation expectations leads Mishkin to conclude, “Anchoring of inflation expectations is not a deus ex machina. It must come from somewhere, and since Milton Friedman’s adage that “inflation is always and everywhere a monetary phenomenon” is still true, monetary policy must be the source of the change in the evolution of long-run inflation expectations.” [Emphasis added]

Inflation has remained low in recent years because sound monetary policy has kept the public’s inflation expectations well-anchored. This is Governor Mishkin’s thesis and it is fast becoming the conventional wisdom. In my opinion, such thinking represents the Anthropic Principle run wild. It is almost certainly wrong, and it may well be dangerous.

Let’s take a closer look at the statement that “the public’s [inflation] expectations stood at a high level of 7-3/4 percent at the start of the 1980s.” If you ask a scientifically selected sample of voting age adults whom of three candidates they support for a particular office, you can get a statistically valid result. The field of choices is limited and known, and the electoral process is well understood. But few adults even know the technical definition of inflation. (Hint: It’s not the cost of living). Fewer still have access to any detailed data on past inflation. And unfortunately, many adults would not be able to answer a question like, “If a head of lettuce costs $1.49 today, what would it cost if its price rose 7.75%?” A poll of inflation expectations is more than likely just a bunch of random guesses based on the flimsiest knowledge. Of course, those guesses can be averaged to reach “the answer” that then becomes “what the public thinks,” because the observer so defines it. In reality, “the answer” may be just noise.

Monetary policy, which is set by the Federal Reserve, is the other side of Mishkin’s equation. The Fed can only do two things. As a body, it can establish a target for the interest rate charged on overnight, unsecured loans between banks. Individually, members of the Federal Reserve Board and Federal Reserve Bank Presidents can express their opinions in public forums. Federal Reserve officials observe that the rate of inflation tends to fall some time after they begin raising the fed funds target rate. They observe that inflation expectations remain low as their public communications continually emphasize a commitment to fight inflation. By the early1990’s the Fed was coming to the conclusion that its actions and its officials’ speeches were contributing to the fall in the inflation rate. Today the Fed appears to believe that it is the contributing factor to low inflation. But is it really? Are our instruments appropriately calibrated and are we properly positioned to observe and fully assess the impact of Federal Reserve monetary policy?

For some perspective, let’s take a look back into recent monetary history. The Great Inflation of the 1970s and early ‘80s was ultimately quelled not by the Fed’s decision to take certain actions or by speeches, learned papers or Congressional testimony. Rather, it was quelled by the decision of Federal Reserve Chairman Paul Volker to do…nothing. In the fall of 1979, Volker announced that the Fed would stop setting a fed funds target; it would simply allow market action to determine whatever rate seemed appropriate. The result was several years of wildly gyrating interest rates and ultimately a major recession, but inflation began falling late in 1981 and it didn’t stop for more than 20 years.

I do not mean to leave the impression that the Fed has no impact on inflation or that it hasn’t played an extremely important role in maintaining the unprecedented period of economic stability we have enjoyed for so long. But its power and influence does not derive from what it does. How can the Fed, with nothing but its control of one interest rate and a bully pulpit, possibly control the huge, complex and dynamic force of inflation? No, the secret of the Fed’s power is our belief in it. The Fed provides the necessary illusion of stability and comfort in a fundamentally uncertain and uncontrollable economic landscape. As for inflation, the real forces keeping it in check are the globalization of production, information, labor and capital. But that’s a story for another commentary. The point here is that if the Fed is not nearly as potent as Governor Mishkin contends, its ability to control a future outbreak of inflation, should one occur, may be much more limited than we now imagine. Illusions can be dangerous flaws for institutions, not just individuals.