AUGUST
2005

 

By
Larry DeBoer
 
Professor of
Agricultural Economics
Purdue University

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08-25-05

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After Greenspan


Each year at about this time, my department asks me to do a forecast for the U.S. economy for the coming year. I keep track of how well I do. Let's just say that forecasting is a humbling experience.

Over the past year, though, one economic variable has been easy to forecast. It's the federal funds interest rate, the rate at which banks lend reserves to each other overnight. The Federal Reserve uses open market operations to set the federal funds rate. It buys Treasury bonds from banks for money, to increase bank reserves. Banks cut the federal funds rate to lend these extra reserves. It sells Treasury bonds to banks for money, to decrease bank reserves. That increases the federal funds rate.

The Fed's Open Market Committee (FOMC) meets every six weeks to decide what to do with interest rates. Since June 2004, for ten meetings in a row, the FOMC has announced a quarter point increase in the federal funds rate. You can see the FOMC's press releases at www.federalreserve.gov/fomc.

Last August, when the rate was 1.5 percent, I could have counted the eight meetings to this August and predicted an increase to 3.5 percent. I would have been right. But I hedged. Surely they'd miss raising the rate at least once! They didn't. Sometimes forecasting is hard because forecasters make it hard.

Suppose the FOMC keeps raising the rate a quarter point at each meeting through next August. That's eight more meetings. The federal funds rate will be 5.5 percent.

But I'm hedging again, because of the Taylor Rule. The Taylor Rule was invented by Stanford University economist John Taylor and the U.S. Treasury Department. The rule links the federal funds rate to the inflation and unemployment rates. When the inflation rate rises, the rule says, the FOMC will increase the federal funds rate to slow down the economy. When the unemployment rate rises, the FOMC will decrease the federal funds rate to speed up the economy.

The version of the Taylor Rule that I like says that if inflation continues at 2.5 percent and unemployment remains at 5 percent next year (that's my forecast), the federal funds rate will be set at 4.5 percent.

At one-quarter point per meeting, the FOMC will hit 4.5 percent at the two-day meeting ending Feb. 1. According to the rule, the federal funds rate will rise to 4.5 percent by Feb. 1 and then stay there for most of 2006.

Funny thing about that Feb. 1 meeting, though. It may be a changing of the guard. Fed Chair Alan Greenspan is scheduled to retire in January 2006. The Feb 1 meeting may be the first under the new chair of the Federal Reserve.

President Bush will appoint the new chair, and he has us guessing. Three candidates are mentioned a lot. Benjamin Bernanke is a Princeton economist and former Fed governor who's now head of the President's Council of Economic Advisors. Martin Feldstein is a Harvard economist who was the head of the Council for a while during the Reagan administration. Glenn Hubbard is a Columbia University economist and dean who headed the Council earlier in President Bush's term. There are others who get mentioned, too, such as Lawrence Lindsay, Roger Ferguson and even John Taylor himself.

What will the new Fed chair do? He may want to reassure financial markets that Greenspan's policies will continue. Following the Taylor Rule would be one way to do that. But he may decide that if he doesn't keep raising the federal funds rate he'll seem soft on inflation. The markets wouldn't like that.

It's possible that on Feb. 1 Alan Greenspan's successor will be Alan Greenspan. Greenspan will stay on until a new chair is appointed and confirmed, and the new appointment could be delayed. In that case, it's more likely that the FOMC will hold at 4.5 percent.

It would be a good idea, though, if the transition to the new Fed chair is handled smoothly. The markets of the world are watching.

 

 

Writer: Larry DeBoer,
Editor: Olivia Maddox,