Can The Fed Stop The Next Recession? Business Can't Bank On It

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by: Dr. Bill Conerly

The Federal Reserve makes decisions based on great academic economists and veteran bank and corporate executives. Politics is minimal, at least compared to most other government decisions. Tremendous resources support the decisions, with great economists on staff, massive data banks and access to outside experts. You would think that the Fed can prevent recessions. You would be wrong.

The Fed just released minutes from the policy meetings held in 2008, as they do regularly with a five-year time lag. The minutes depict a massive failure of the technocratic ideal of putting some smart people in the room and letting them run things.

Chairman Ben Bernanke is quoted as saying that he is "confounded and muddled." The Fed eased early in 2008 and patted themselves on their backs. In March, after the Bear Stearns rescue, Janet Yellen said that "the likelihood of a severe financial panic has diminished." That could actually be accurate, if she meant that the likelihood was going from 99 percent to 98 percent. In meaningful terms, it was just plain wrong.Click to enlarge

Tim Geithner, then president of the New York Fed, said in March 2008, "It is very hard to make the judgment now that the financial system as a whole or the banking system as a whole is undercapitalized. Some people are out there saying that . . . . Based on everything we know today, if you look at very pessimistic estimates of the scale of losses across the financial system, on average relative to capital, they do not justify that concern." He further suggested that talk about the risks within the financial system was harmful, clearly favoring a "trust us" message to the public. This discussion happened well before Lehman declared bankruptcy and credit markets melted down.

However, the people making decisions at the Fed (the Board of Governors plus the 12 regional bank presidents, four of whom vote at any one time) are neither stupid nor ignorant. They are all talented, and they know the issues.

(On a personal note, my lasting memory of the Fed Board is that I was congratulating myself for having been invited to meet with them, and then Alan Greenspan asked the toughest question I had fielded since my doctoral dissertation. It was also the most critical question for the economy at the time. And I had to confess that I didn't know the answer.)

Would a different set of people have come up with better policy in 2008? Scott Sumner observed, "The Fed does roughly what a consensus of elite academic economists think they should be doing." The problem, in short, is with not with the people at the Fed.

Hubris is the first problem highlighted by the Fed transcripts. Our monetary policy leaders were too confident about their understanding of the economy and the financial system, and too confident in their ability to use the tools of monetary policy to keep the country out of recession.

Hubris also infected the business community. On the financial side, investors and bankers overestimated their own knowledge of risk and economics. Non-financial executives overestimated their ability to plan on the basis of common forecasts of the economy.

Business Planning Lessons: Today's business leaders should add a strong dose of humility to any forecast of the future. The economy is too complex for easy prediction. Not even our top economists do a good job of forecasting recessions. Moreover, our government is not able to prevent future business cycles. The Fed's 2008 minutes make clear that we should avoid that line of thought.

What is a business leader to do if the Fed cannot prevent the next recession? Develop flexible plans, as I've discussed in a series of videos, Business Planning With a Risk of Recession.

When will the next recession come? I'm not sure. As of this writing (February 2014), I think the risk is fairly low, on the order of 10 percent risk of a recession beginning in the next 12 months. That's a large enough risk to justify contingency planning, but not large enough to completely hunker down. Those videos linked to above explain contingency planning for upside possibilities as well as downside.

For my latest economic forecast, see Economic Forecast 2014-2015: Looking Better With Help From Oil and Gas.