Monday, January 24, 2011

Does The Fed Have The Right Information? Reprinted

The following post is a reprint of my January 4, 2008, post on another, short-lived blog of mine. I am reprinting the post because 3 years later there is still a need for solutions to our economic problems of slow GDP growth and high unemployment and there is still an ongoing debate as to what are the best monetary and fiscal action policies to follow:
January 4, 2008

Does the Fed have the right information?

Does the Federal Reserve have the best information to control inflation and maintain employment growth? Has the Fed been too passive in accepting the current supply of economic data?

The Fed, like the rest of us, relies on published economic data, surveys, and anecdotal evidence to assess the state of the economy, and most of that data reflects past or concurrent economic indicators of the health of the economy. The Fed does not have magical powers or a crystal ball to tell it what will happen next. The Fed does not have a secret recipe that makes it a better predictor of the future of the US economy than ordinary investors. But, the Fed does attempt to maintain a sustainable level of economic growth that will cause neither inflation nor excessive unemployment based on all available information.

In fact, the Fed and many economists look at bond yields, including the slope of the yield curve, and stock market prices to assess future GDP because these prices contain investor expectation data about future interest rates, inflation, and economic growth.

But is the Fed too passive in monitoring the current supply of information. Why doesn't the Fed in conjunction with the Treasury create a government issued financial instrument that would reveal more about the future of the US economy than is currently available?

For example, Treasury could issue a GDP linked bond whose semiannual coupon payment would be a fixed percentage of the most recent nominal GDP number at the time of coupon payment. This would force investors, in pricing the bond, to incorporate explicit expectations about future GDP. The price of the bond would reflect the present value of all future GDP growth over the period until maturity. And because the bond would be discounted (present valued) based on nominal interest rates, the current price would be a measure of total real (inflation adjusted) GDP over the life of the bond.

GDP linked treasury bonds, through analysis of embedded forward rates, would allow the Fed to see in what future time periods over the future life of the bonds that the market was predicting a slow down in economic growth. It would also allow the Fed to see if its policies were merely time shifting future economic growth into other periods without actually creating any overall growth in the economy.

Over time, the premium on the rates paid on these bonds over plain treasury bonds would allow for an analysis of the inherent risk of the US economy. And whether this risk changes over time.

Changes in the price and future embedded rates of GDP linked bonds would allow for an analysis of the effect of legislative and other governmental policies on US future economic growth. If the government introduces or discusses policies and there is an immediate decrease in the price of the bonds then clearly the policies are not good for maximizing future economic growth; although, they may have other benefits.

Having a GDP linked treasury bond would allow the US to maximize future economic growth. The bonds would also allow information about future economic activity to be discerned and assigned to a specific future time period. GDP linked bonds would allow the populace to see if our politicians are doing positive things for the future health of the US economy after their terms in office end before we actually are in those time periods.

The Fed does have very good mathematical economic models to project future economic growth. However, like all models, they work only as long as the relationship among the variables remains static or predictable. So for example, one of the Fed's models mistakenly predicted that we should have been in a recession for the last several years because it used historical relationships about the relative investment in fixed capital versus intellectual property and missed the increase investment in intellectual assets. When correcting the model for the actual relationship between intellectual and fixed property investments over the last several years, the model accurately predicted the actual historical economic growth, but failed on a prospective basis because of the change in the relationship of the variables.

The Fed should take a more active role in deciding what information it can obtain from the investment markets, design instruments accordingly, and work with Treasury in issuing and creating liquid markets for these information designed securities.

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