![South Africa's government in recent years voted to jail people who make unauthorized and inaccurate forecasts. Good thing for the Federal Reserve that their bad predictions don't carry consequences. [Credit: University of MN]](https://i0.wp.com/www.dougsbriefcase.com/blog/wp-content/uploads/2014/01/Credit-UMN.jpg)
South Africa’s government in recent years voted to jail people for making unauthorized and inaccurate weather forecasts. Good thing for the Federal Reserve that their bad predictions don’t carry consequences. [Credit: University of MN]
Holding people accountable for their predictions seems a bit harsh in this season of predictions. But the South Africans do have a point: predictions have consequences. That’s as true of predictions about the economy as about the weather, something that the Federal Reserve might do well to ponder.
The South African bill’s proponents argued that the law was necessary to prevent panics that might arise as a result of private forecasts of weather disasters. Such forecasts, when false, could lead to evacuations of villages and other costly, disruptive and excessive reactions. So the bill would make it illegal to disseminate “a severe weather or air pollution-related warning without the necessary written permission from the Weather Service,” a government entity. Violators would be subject to fines and up to 10 years imprisonment. The government’s weather service would remain exempt from such penalties. It alone could forecast bad weather with impunity. It holds a license to err.
As does our Federal Reserve. Diana Furchtgott-Roth of the Manhattan Institute has chronicled the Fed’s abysmal recent record of forecasting economic performance. She notes that:
- In 2010, the Fed forecast that the economy would grow at about 4 percent in 2013.
- In 2011, the Fed’s forecast for 2013 growth declined to 3.2 percent.
- In 2012, it was lower still, at 2.6 percent.
- The Fed most recently guessed that 2013 GDP growth will be about 2.3 percent.
The Fed’s shifting and erroneous 2013 forecasts are no anomaly, she wrote, citing the following:
- In 2010, GDP growth in 2012 was supposed to be 4 percent; it ended up at 2.8 percent.
- In 2010, the median Fed forecast for 2011 growth was 3.3 percent. The reality was 1.8 percent growth in 2011.
What is particularly striking is not only that the Fed is consistently wrong, but that it consistently errs in one direction: it overestimates economic performance, leading Furchtgott-Roth to suggest that one qualification for Federal Reserve Governors is that they be “professional optimists.”
This optimism is no doubt rooted in the agency’s confidence in its own economic models. Unlike weathermen, the Fed doesn’t merely forecast the economy’s performance. It seeks to influence it through the creation of money. Lately, it has binged on money creation.
The Federal Reserve facilitates liquidity, a fancy way of saying that it helps keep the banking system from running short of cash. Banks often need to borrow at the end of the day to settle transactions. The Fed sets the target rate that banks pay for such overnight borrowing, helping to grease the wheels of the financial system. When it believes there is too much money in the economy, creating an inflation risk, it raises the target rate; when money is too tight, it cuts it. The Fed moved this rate effectively to zero in December 2008, something it hadn’t done since its founding in 1913. It has remained at zero percent for the past five years. It recently announced that it plans to keep it there well past the time that the unemployment rate declines below 6–1/2 percent, its previous endpoint.
But when growth remained unexpectedly tepid despite its extraordinary zero interest rate policy, the Fed took another bold step. It instituted several rounds of quantitative easing (QE), creating enormous amounts of money and exchanging it for government debt and mortgage-backed bonds. Such instruments, unlike cash, are illiquid and therefore can’t easily be lent by banks to businesses and households. The idea behind QE was that, by replacing banks’ illiquid assets with newly-conjured cash, it would induce them to lend more, stimulating economic activity and spurring job creation
Largely as the result of QE, the Fed now holds nearly $4 trillion in bonds on its balance sheet. But the money it created to buy these bonds hasn’t coursed through the economy the way the Fed’s models had forecast, as various economists have pointed out. Indeed, the velocity of money — which measures the rate at which money is exchanged for goods and services throughout the economy – is at historic lows.
The Fed is creating money, but that money doesn’t seem to be finding its way into the broader economy. This isn’t what the Fed’s models predicted. No one is sure why its QE program hasn’t worked as forecast. One would expect that banks, flush with cash, would be eager to lend money to businesses and households, spurring demand and stimulating growth. That hasn’t happened. Small businesses say that banks are too stingy with loans. Banks say that businesses just don’t want to borrow. The results are, in any case, inarguable: bank loans to small businesses declined by 27 percent between September 2008 and September 2013.
Larger, publicly traded corporations, by contrast, have ready access to credit. Such companies don’t have to rely exclusively on banks. They can issue their own bonds. In 2013, corporate bond issuance surpassed $1 trillion for the second consecutive year. It is only the third time in history that it has exceeded that threshold. The market cap of publicly-traded concerns also has risen. The S&P 500 rose by nearly 27 percent in 2013. Large banks did especially well, with S&P financials posting a 33 percent increase. QE is good for Wall Street, but not so much for Main Street.
The Fed’s intervention into the real estate market has produced similarly asymmetrical results. The agency plays a major role in government efforts to boost housing prices, buying up nearly $1.5 trillion in mortgage-backed securities. That has led to some recovery in the residential housing market, with average prices rising by 13.6 percent over the course of 2013. But that improvement, too, has been uneven. A recent Wall Street Journal analysis of Zillow data found that the recovery in home prices in a number of cities has been evident in affluent communities, but not in more modest neighborhoods. Home prices in prosperous Palo Alto (CA), for example, have risen 40.4 percent (average price: $2,353,100) above their pre-2008 peak, but have declined by 53.8 percent in the nearby working class city of San Pablo (average price: $225,300).
The Fed’s policies appear to have been selectively beneficial but broadly unproductive, fueling inequality amid a limping economy. Big banks, large corporations, well-heeled investors and owners of luxury homes seem to have benefited disproportionately from these policies. The Fed expected something different: a broadly favorable effect on the economy. Which is one reason why its GDP projections have been consistently cheery. And consistently wrong.
Fed intervention has become Wall Street’s drug of choice, helping propel stock prices to record levels while avoiding (to this point, at least) a bond market collapse. Investors have so far tolerated the agency’s recent decision to begin gradually tapering its money creation, with stock prices rising by 3.5 percent over the two weeks since the announcement.
The real test of the Federal Reserve’s resolve will come if the stock market falters at some point. My prediction is that the Fed will respond to such a downturn in equities with renewed quantitative easing. The Fed’s bias toward money creation will effectively become a permanent state of affairs, waxing and waning in response to Wall Street’s performance.
That’s my prediction, anyway. But please don’t throw me in jail if it proves wrong.