The Worm Always Turns

As with all natural phenomena Dennis says when it comes to the economy, what goes up will come down and vice versa.

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July 20, 2004. Early in my career, I received sage advice from a senior faculty member ? really my mentor before mentoring became a standard part of on-the-job training for young university professors. I was advised to bear in mind, when it comes to economic trends, the worm always turns.

My mentor was right. What goes up will come down. Witness the unemployment rate. And, what has come down will go back up. Witness interest rates.

The challenge is, figuring out when. That is, calling the turning points. Good forecasting depends upon good information ? what we economists call, transparency. By this we mean, all relevant economic information is readily visible to both decision-makers and to forecasters. We also take it to mean that decision makers will react to new information quickly and rationally. Thus, economists armed with theory that defines rational behavior, can predict changes in economic events once informed with the same data that are used by decision-makers.

An impediment to both forecasters and decision-makers is, information is not always transparent. Indeed, many actors on the economic stage purposely try to obscure their intentions. For example, corporate managers may try to disguise intentions to introduce new products or change prices in order to gain an advantage, albeit temporary, over competitors. This does create noise for economists. But, that kind of noise seldom creates huge forecast errors. Mitigating the noise effect is the relatively small size of most businesses compared to the overall economy, and a fairly rapid competitive response by other firms. Further, microeconomic theory does a pretty good job of predicting business behavior.

More problematic is, unexpected behavior by large economic institutions. In particular, the Treasury Department with the federal budget, and the nation?s central bank, the Federal Reserve System. This is the stuff of macroeconomics.

Macroeconomic theory is reasonably accurate in predicting the impact of a policy change by the likes of the Federal Reserve or the Treasury Department. The bigger difficulty is, transparency. That is, gaining insight into behavioral or policy changes intended by such institutions.

The good news is, things are changing for the better. Not so long ago, the Federal Reserve concealed itself in secrecy. In 1975, it went to court to defend its right to secrecy, when petitioned to make its deliberations public. Its policy decisions ? raising or lowering interest rates, for example ? were often surprises; surprises that sometimes caused forecasters to widely miss the mark. Its secrecy even brought about an industry of ?Fed-watchers? who would try to ferret-out and decipher its motives.

Recently, however, the Fed has become more transparent. And the Fed-watchers obsolete. Recently the Federal Reserve reversed its cheap money policy and announced an increase in the short-term interest rate. In the past, this could have rendered economic forecasts wrong and cause near-panic behavior in financial markets. This time around, there was barely a quiver.

What changed? The end of the Fed?s low-interest-rate policy actually began about three months earlier. At that time, the Fed made it clear that it would raise interest rates once the economic recovery showed convincing signs of job growth. Subsequently, buoyant employment figures in March, April and May virtually assured the policy change.

Consequently, there was hardly an economic ripple when the Fed acted. Long term interest rates, not directly controlled by the Fed, had already been edging up. Interest-sensitive behavior, such as mortgage refinancing, was well into the adjustment process. The worm turned. But because of increased transparency, neither economists nor the public at large were caught flat-footed. Forecasts were more accurate, and the public has better information upon which to base future decisions.