The case for thinking that effective central banking is all about managing expectations is persuasive. There are lots of formal papers arguing for no less, and the numbers confirm that this is indeed how the world works.
As everyone recognizes, aggregate demand expectations have been falling. And rightly so, given the latest news that GDP has been revised down. More of the same appears to be coming, based on economists' falling projections for economic growth, as the chart below shows (courtesy of the Philadelphia Fed's third-quarter survey of forecasters).
The falling trend should come as no shock, considering falling expectations for inflation in recent months. If the market's outlook for inflation continues to fade, so too will the crowd's view that the economy's growth rate will weaken further. If the Federal Reserve ignores the trend, that's a defacto monetary tightening—even at a near-zero nominal Fed funds rate. Expectations have a habit of becoming reality under current conditions.
Why might we disagree? The fear of higher inflation is the standard worry. But that's exactly what's needed at the moment. Not as a long-term proposition, of course, but it's necessary now. That creates new challenges down the road, and perhaps sooner than we think, but it's a secondary issue for the immediate future. The fact that the Fed has yet to raise (or at least stabilize) inflation expectations is testament to the problem. You could argue that inflation expectations are falling because productivity is rising, but that's a weak argument, given the latest report on labor market productivity.
The key unknown is how will the Fed react in the coming weeks and months. Yes, the remaining monetary levers aren't as potent as they were, given the near-zero nominal rates. As such, we can't be sure that they'll be effective. On the other hand, not using the remaining tools runs the risk of giving the crowd a new and potentially potent incentive to continue revising expectations down. The bigger challenge is all the guessing that's swirling about. Will Ben do something? Or not?
Mark Thoma isn't so sure. As he wrote earlier today:
Rereading Federal Reserve Chairman Ben Bernanke's recent speech and measuring it against the incoming data leaves me with a pit in my stomach. I sense Bernanke reveals in this speech he is the proverbial emperor without clothes, short on policy options but long on hope. A last ditch attempt to persuade us that as long as we don't believe deflation will be a problem, it will not be a problem. But he faces the same challenge as did then President Gerald Ford. All hat and no cattle. You need to be ready to back up your talk with credible policy options. While Bernanke outlined possible policy options, reading between the lines makes clear he lacks conviction in the viability of any of those options. Simply put, Bernanke is not ready to embrace the paradigm shift bold action requires.Until the incoming economic data surprises boldly on the upside and/or the Fed chairman convincingly persuades the market to expect higher (or at least stabilized) inflation, there's a surfeit of uncertainty rolling about. In that case, the market's likely to err on the side of caution, i.e., shun risk, seek safe havens.
This post has been republished from James Picerno's blog, The Capital Spectator.