The Roman poet Horace wrote that "life is largely a matter of expectation." Fed policymakers should heed this lesson.
Over the past couple of months, Federal Reserve Chairman Ben Bernanke and other members of the Federal Open Market Committee have been toying with investor expectations. First they hinted the Fed may start cutting back on its $85 billion monthly purchases of government bonds and mortgage-backed securities. Then, in June, policymakers suggested there are no plans to taper off all the new money now being pumped into the banking system.
The effect of these Fed speeches is more financial-market volatility. Investors are continuously changing their expectations for interest rates, economic growth and inflation.
Apparently, the Fed isn't managing expectations well.
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By law, the Fed has a dual mandate: to promote full employment while keeping prices stable. It is supposed to try to keep both inflation and unemployment low. But economists have long known that these two economic conditions often work against each other.
In 1958, English economist A.W. Phillips detailed the negative correlation between inflation rates and unemployment. This empirical relationship was soon confirmed by other economists using U.S. data.
Today's Fed has said that a 2 percent rate of inflation would be an OK price to pay for lower unemployment. But just 10 years after Phillips' finding, economists Milton Friedman and Edmund Phelps showed that such policy tradeoffs were effective only for short periods. In the long run, low interest rates and the consequential growth in the money supply have no real effect on the economy.
According to these later findings, the Fed can't do anything for the economy's long-term unemployment rate. This appears to be the case today. Despite low interest rates for more than five years, the U.S. unemployment rate has remained well above average.
Phelps went on to show that when policymakers try to take advantage of any short-run trade-off between unemployment and inflation, they cause negative consequences. When the money supply is expanding, people come to expect higher inflation - that is, they raise their inflation expectations. This makes the tradeoff in the Phillips curve (the line in a chart with X and Y axes showing that as inflation rises, unemployment falls) worse. Higher inflation is set against higher levels of unemployment. The whole curve shifts up.
So when policymakers intervene in financial markets they affect prices now, but they must concern themselves with what is likely to happen down the road. Expectations matter.
By buying mortgage bonds directly, the Fed was hoping to keep mortgage rates low and encourage home buying. Ironically, when potential buyers expect this, they jump in.
According to the Mortgage Bankers Association, applications for conventional loans in the U.S. rose rapidly in June and are 16 percent higher than a year ago. According to the Intermountain Multiple Listing Service, existing home sales in Ada and Canyon counties are rising at annual rates of 36 and 29 percent, respectively.
It simply goes to show that all the tinkering with interest rates and bond buying over the past few years has been ineffective. A return to more normal monetary policy and interest rates is likely to be better for the economy. That's what we should expect.