The Fed's Undistinguished Macro Discussions

by: James Picerno

Anticipating recessions is hard, especially the ones in the future. Just ask the Fed officials who attended the January 2006 FOMC meeting to discuss the outlook for the economy. The newly released transcripts from this meeting have attracted attention far and wide about Fed's ability, or lack thereof, to see macro changes. Unfortunately for the central bank, the reviews are in and most pundits aren’t impressed (see news reports here and here, for example.) The Atlantic's Derek Thompson finds the transcript "damning" in light of the "blithe ignorance in the face of impending doom."

At issue is whether there was sufficient warning in the stumbling housing market to alert policy makers of the turmoil that lay ahead in early 2006. It's all obvious in hindsight, of course, prompting comments like this one from Slate's Matthew Yglesias:

Some people sat around looking at the US economy from 2002-2006 and thought all was well. But many people looked at it and could see clearly that all was not well. That we were on an unsustainable path and that we were primed for a crash. The main feature of the unsustainable path was huge inflows of foreign capital into AAA-rated American financial instruments, including US government debt, mortgage-backed securities, etc. These unsustainable flows were distorting employment patterns and sustaining unsustainable living standards. Americans were maintaining broad-based consumption growth only through excessive household indebtedness and underpayment of taxes relative to the quantity of services being received. Someday soon, the capital flows would come to an end and we'd have a version of a classic developing economy sudden stop of "hot money," except it would be happening to a rich industrialized nation. The value of the dollar would crash, restraining inflation would require high interest rates, and the US economy would feature a period of painful restructuring.

Some analysts argue that the Fed's monetary policy was overly accommodative, which unleashed a housing bubble. But Scott Sumner disagrees, in part because the housing market was correcting for several years before we reached the oh-my-god-it's-all-going-to-end-NOW moment in September and October of 2008.

One interesting discussion point to consider amid all the chatter about the 2006 minutes and what should have been done is the fact that the Treasury yield curve looked rather ominous when the FOMC convened six years ago. The spread between the 10-year Note and the 3-month Treasury bill was unusually low as of the January 31 meeting: less than 20 basis points, or down from nearly 400 basis points in mid-2004. Even in 2006, there was a large amount of research advising that the yield curve was a powerful signal for assessing recession risk. In particular, when the yield curve inverts, a contraction in the economy almost always follows.

To be fair, the curve hadn't inverted as of January 31, 2006, but it was close, and it was obvious that the spread had been falling sharply in recent history. Later in 2006, the yield spread would go negative, sending a shot across the bow for the business cycle—a warning that would be proven timely once again when a new recession arrived at the close of 2007. Many dismissed it at the time, but now we know better.

A 2008 study by the San Francisco Fed notes:

… forecasters appear to have generally placed too little weight on the yield spread when projecting declines in the aggregate economy. Indeed, we show that professional forecasters appear worse at predicting recessions a few quarters ahead than a simple real-time forecasting model that is based on the yield spread. This relative forecast power of the yield curve remains a puzzle.

These days, as analysts again struggle with deciding if a new recession is near, probably can't rely on the yield curve this time, thanks to the Fed's unusually efforts at keeping the short end of the curve at roughly zero. Does that distort the value of the curve for predicting recessions? It's debatable and only time has the answer. For the moment, the 10-year/3-month T-bill spread is positive at around 200 basis points. Historically, that tells us that there's a recession isn't imminent, although that doesn't stop some analysts from predicting that a new downturn is near.

Relying on predictor is dangerous, of course. On that note, if we have another recession soon, the value of the yield curve will be tarnished. So it goes in forecasting the business cycle. Expecting what worked before to be a reliable guide now and forever more is expecting too much. Still, it's hard to read the 2006 transcripts and see the Fed officials as distinguished in the art/science of macro forecasting. Of course, the central bank can redeem itself when it meets later this month (January 25-26). We're not looking for much, just a simple prediction about the risk of a new downturn for the year ahead. An accurate prediction would be nice. But, hey, no pressure.