Goldman Sachs Economists on the Fed, This Should be Good
David Wessel (who did In Fed We Trust, which I have not yet finished but pretty much enjoyed - I've carried it with me on the Muni for the last month, does that count?) says Goldman analyzed the Fed or something. Who cares?
The Federal Reserve on Wednesday spelled out the factors that will determine how much longer it’ll keep its key interest rate near zero: as long as it sees “low rates of resource utilization, subdued inflation trends, and stable inflation expectations.” This already is setting off an intense scrutiny of the Fed’s new dashboard, the gauges that it — and, as a result, the markets — will be watching closely now.
In a research note to clients, Goldman Sachs economists offer their list:
“What indicators should investors watch to judge whether these conditions remain in force? For resource utilization, the broadest measure is the overall “output gap” between actual and potential GDP — but in practice the unemployment rate may be more important as a measure of utilization. For inflation trends, core inflation — particularly the PCE measure used by the Fed in its forecasts — is most important. And for inflation expectations, Fed officials are probably looking at a range of measures, most importantly market-implied expectations of future inflation (i.e. the five-year, five-year forward TIPS spread) and longer-term household expectations (including the University of Michigan’s median five-to-ten-year measure).”
And which gauge is most likely to move first?
According to Goldman:
* We see utilization as least likely to be an issue in 2010 – spare capacity is so large that it will take a long time to whittle away even with strong growth. In fact, where the unemployment rate is concerned, a simple rule of thumb known as Okun’s Law suggests that it could take many years to return to “normal” unemployment rates. (The rule is that two percentage points of above-trend growth, i.e. growth in the high 4% range, would reduce the unemployment rate by one percentage point per year.)
* Core inflation is also highly persistent and we view the predominant forces as downward. Headline inflation, on the other hand, should perk up somewhat given commodity prices and easing year-ago comparisons. It is the most likely (although not very likely) to move above comfortable ranges in the next year, although as noted above, it is probably viewed by most FOMC members as secondary to core inflation.
* Inflation expectations are the hardest variable to predict, and the process by which long-term expectations are formed is not especially well understood. Therefore, they have to be seen as a risk factor. However, insofar as some portion of expectations is “adaptive” (reacting to past inflation rather than predicting future inflation), lower inflation now would seem to point towards downside, rather than upside, risk to inflation expectations.
This feels slightly obvious to me. Are we announcing that markets are paying attention to the Fed now? That's funny, this week's FOMC announcement was the least exciting yet.
Let's have Goldman audit the Fed. A good auditor knows the industry, who better than the Goldman rats?