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Peter Crabb: If only the Fed would listen to what markets are saying about inflation

It’s a case of he said, she said. The “men” of the Fed have one view, “lady market” another.

The Fed announcement following its two-day policy meeting this week says the recession is easing but economic weakness will keep a lid on inflation. The Federal Open Market Committee, the monetary policy making group within the Federal Reserve, said, " prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time."

“In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

Critics of the Fed have long said these policymakers suffer from a time inconsistency problem. What the Fed says it is going to do, such as protecting the value of the dollar, and what it subsequently in fact does differ dramatically.

The value of the dollar was higher the morning before the Fed’s announcement, but sold off along with stock and bond prices in the afternoon. Gold prices were up throughout the day. Market participants may just not believe the Fed.

In addition to these doubts, the Fed is experiencing internal arguments.

As reported by Krishna Guha for the Financial Times, “there is a widening divide among these policymakers over inflation risks. The Fed leadership believes huge spare capacity will provide a good safeguard against inflation.”

But some members of the Federal Open Market Committee have said publicly that estimates of spare capacity may be overstating the slack in the economy. Further, economists at the Federal Reserve Bank of San Francisco reported earlier this month that the output gap cannot be directly measured, with the implication that the risk of deflation is smaller than thought.

The output gap is the difference between actual growth in gross domestic product (GDP) and its potential level. This is considering the rate of growth the economy can accommodate if it is fully using all its resources, especially its workers.

With unemployment high and rising, Fed officials can easily argue today that there is a substantial output gap. The problem with watching only the labor market is that asset bubbles can occur well before the employment situation improves.

This means that employment is a lagging indicator. Asset price rises are now. All the money the Fed has injected in the market goes somewhere, such as commodities, well before workers are offered new jobs.

Critics of the current discretionary approach to monetary policy have long emphasized that officials’ actions affect the economy with a long lag and that their ability to forecast future economic conditions is poor.

If only they would listen to the markets.

One of the strongest characteristics of a good business leader is the ability to listen. Successful business leaders are known to listen intently to customer needs, employee concerns and suppliers’ offers.

The “managers” of our economy have plenty of people to listen to and talk with each day, including elected leaders and their own staff economists. They are likely overlooking one key voice – the voice of the financial markets.

In an editorial piece this week, The Wall Street Journal argued that the Fed is ignoring the falling value of the dollar in the foreign exchange market and rising commodity prices, such as $70-a-barrel oil.

But the Fed needs to look at more than just today’s prices. The Fed needs good forecasts of tomorrow’s prices. A market with information on the expected prices tomorrow exists today. It is the commodity futures market.

Futures and other financial markets are often thought of more as casinos than a source of business management, but good managers read these markets frequently for key information on future business conditions.

A futures contract is a standardized agreement to deliver or take delivery of an asset, such as corn or gold, at some time in the future. Since the contract is standardized. Only the price is determined by traders in futures contracts. The actual contract specifies all other particulars, such as the quantity of the asset delivered and the ending date of the contract.

Trading of standardized contracts, such as those on the Chicago Board of Trade and Chicago Mercantile Exchange, provides liquidity and guaranteed settlement. The exchange provides a guarantee to traders that the other party to the contract will meet its obligations. The futures markets have high volume and thus, what should be better information on future price conditions.

The standardized futures markets have greater participation than what are known as off-market, or over-the-counter forward markets. Trading volume in futures has risen dramatically the past two decades. With high volume and high participation from people with real money on the line, you get a fair forecast of what prices should be down the road.

The futures markets are therefore an unbiased forecast of tomorrow’s prices. Currently, the futures market predicts much higher prices for both gold and oil. In futures trading Wednesday, gold and oil prices are expected to rise 6 and 16 percent respectively over the next three years.

The markets say inflation is unlikely to remain “subdued”. As she may often say, “If only he would listen to me.”

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.

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