A Keynesian Puzzle for Fed Watchers

The Wall Street Journal and Bloomberg surveys both report that Fed watchers and economists continue to expect the Fed to raise interest rates beginning in mid-2015.  There is enough widespread agreement that the Fed will move on interest rates next year that some forecasters now predict that the Fed’s next policy statement will drop the phrase “for a considerable period of time” when describing how long rates will remain at current levels. At the same time, a few Fed officials and regional Fed bank presidents have commented on whether the Fed should raise rates very soon, or much later, than the consensus guess of next July.

The FOMC or Federal Open Market Committee, the Fed’s policy making and rate setting group, can move very quickly when necessary.  Each time the FOMC meets it sets its interest rate targets for the six to eight weeks until the next meeting. While the Committee publishes long term projections for the economy and discusses how conditions will change over the next year or more, its time horizon for interest rates is no longer than the time to the next meeting.  When conditions warrant, it will gather by phone to decide and act quickly. Forecasting what the Fed will do next July depends on what the economy will look like next July, not what it looks like now.

However, forecasting the Fed’s likely action six months into the future is even more complicated that just predicting what the economy will be six months forward. In his  General Theory of Employment, Interest and Money, Keynes describes the forecasting problem facing stock market investors; the same problem confronts Fed watchers.  Keynes describes a fictional beauty contest run by British newspapers where subscribers are asked to choose the contestants who will be judged most attractive by the largest number of subscribers rather than the contestant each individual subscriber perceives as most attractive: forecasting the forecasts of others.   Fed watchers need to forecast what each voting member of the FOMC will be forecasting for the economy next July.  To make the challenge a little worse, there are two open seats on the Federal Reserve Board which might be filled by July.

Most analysts and economists commenting on the Fed have a lot of experience divining the central bank’s next move, so one would hope that they would be right more often than not.  The additional concern is that current economic conditions are rather unusual and history is probably a flawed guide to the immediate future.  Economic growth is strong enough to promote substantial job creation and push down the unemployment rate.  This is all good and is a reason for the Fed to consider raising interest rates. At the same time, inflation is surprisingly low (1.5% on the CPI), the dollar is gaining strength compared to almost every other currency and may dampen demand for US exports already threatened by slow or slowing growth in most other parts of the world.  On top of all that, oil prices have plunged and oil drillers are announcing cuts in their 2015 capital spending plans. All these factors argue for holding the line on interest rates.

What is the Fed likely to do? Wait and see – no reason to rush into 2015 since the FOMC will have more hard facts about the economy if it waits awhile.  But that won’t help Fed watching analysts who are expected to tell now when the Fed will raise interest rates.

The posts on this blog are opinions, not advice. Please read our disclaimers.

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