How to Succeed at the Fed

Ironically, even as economic fine-tuning and forecasting has gone out of fashion, the most important job in the economy remains that of the Fed Chairman — who is expected to be a top-notch economist and to base his monetary policy decisions on analysis and forecasts.

A harder job

Over the past decade, the task of figuring out what is going on in the economy has become, if anything, even more difficult. That's because seemingly ironclad macroeconomic relationships discovered by economists in the early postwar decades have largely disintegrated.

Take, for instance, inflation, which has been especially difficult to pin down. It would seem that after the experiences of the 1970s and 1980s, when inflation first got out of control and then was throttled by draconian interest rates in the early 1980s, economists would have come to grips with what makes inflation tick.

In reality, it has not happened at all. Economists have blamed the advent of inflation on President Johnson's efforts to finance his Great Society programs and the Vietnam War at the same time, and on the impact of oil price hikes in 1973 and 1979. Today, the situation is very similar. Washington has been funding both tax cuts and an extremely costly foreign war with a massive budget deficit, and oil prices have spiked six-fold from their 1999 nadir. However, there is no sign of inflation, and after two years of interest-rate increases, U.S. long bond yields — the gauge of market expectations of future inflation — remain at the same level as two years ago.

True, in each case you can find a special explanation why traditional relationships failed to hold. The problem is that in "hard" sciences such as physics, when an existing theory starts relying on too many special explanations, it is usually time to look for another, better theory. The problem in economics is that none has emerged since Milton Friedman developed his monetarist creed.

Wall Street Boy

Small wonder that when people tried to pin down Greenspan on his economic forecasts, he resorted to vague pronouncements. This stance proved remarkably reassuring for financial markets and for bond and equity investors. They liked the obscure pseudo-intellectual talk as well as a generally loose monetary policy that provided enough money for the U.S. economy to grow and for financial assets to appreciate steadily. But then again, Alan Greenspan was a product of Wall Street. He was no academic, having completed his doctorate in economics pretty late in life. Most of his career before being appointed to the Fed was spent as a consultant on Wall Street. He understood its psychology very well.

Ben Bernanke comes from a completely different background. He is an academic economist, and a very good one at that. But that could end up being a serious drawback in his new position. The problem is that he believes in economic indicators and in relationships between, say, money supply and consumer price inflation. Instead of telling the market that he watches some secret unconventional indicators — such as global output of left shoes, as Greenspan used to do — Professor Bernanke has already candidly admitted that he doesn't know how many more times he will have to raise U.S. interest rates, and whether or not long bond yields will continue to rise.

That's dangerous talk. Since he assumed his duties at the start of March, major Wall Street indices have revisited their five-year peaks, but they have also showed more day-to-day volatility. The new Fed Chairman will have to learn to speak enigmatically and project an air of omniscience — in other words, become in part a snake-oil salesman — or else lose credibility in financial markets.