Thursday, June 08, 2006

The second moment 

While I don't have much to say about Zarqawi, and not like you'll care at this particular moment, I do have something to say about the dissatisfaction expressed towards Ben Bernanke and the Federal Reserve. Apparently he either says too little or too much. He's scaring not only the US but investors around the world (how dare he!) What is going on?

My answer from a few months ago: It's just a hard time to figure out where to go after the May rate increase. And there's nothing since then that has made it easier, which has led Bernanke to try to digest each wiggle individually, and sometimes in public. We who watch the Fed would almost instinctively inserted the word "unfortunately" in front of "sometimes" in the last sentence, but Catherine Yang thinks Bernanke has a method to his madness.
Bernanke seems to have adopted the central banker's version of Regulation FD, for "fair disclosure," the securities rule requiring public companies to reveal material information to all investors simultaneously. While his predecessor, Alan Greenspan, often signaled his intended message through winks and nods in off-the-record interviews with the press, the new Fed chief is offering little whispered guidance. Such a shift to public discussion, rather than private hints, is consistent with Bernanke's emphasis on transparency.

... In the short run, Bernanke's reluctance to telegraph his thinking privately may increase market volatility. That's a big reason why stocks moved so sharply on June 5 and 6, since Bernanke hadn't prepared investors for the depth of his inflation fears.

Nevertheless, the experience with Reg FD over the past six years suggests that volatility may ease once the markets get adjusted to Bernanke's style. Remember that before Reg FD went into effect in 2000, companies would typically hold private meetings with stock market analysts, feeding Wall Street nuggets of information about whether the company was doing better or worse than expected. Such private meetings, ahead of official earnings announcements, were justified as a way of letting good news -- or bad -- trickle out into the market slowly.

...There's a clear analogy in today's situation. Bernanke wants investors, rather than hanging on his every word, to do their own work on forecasting economic growth and inflation to anticipate the Fed's next move. That should help them think like the Fed, which is basing interest-rate policy on the economy's future course. The quarterback "has to throw where the receiver is going to be, not where he is at the current moment," he said on June 5.

A key to the inflation-targeting approach that Bernanke favors is to have inflation expectations under control as well as actual inflation. He says so himself in 2003:
The maintenance of price stability--and equally important, the development by the central bank of a strong reputation for and commitment to it--also serves to anchor the private sector's expectations of future inflation. Well-anchored inflation expectations (by which I mean that the public continues to expect low and stable inflation even if actual inflation temporarily deviates from its expected level) not only make price stability much easier to achieve in the long term but also increase the central bank's ability to stabilize output and employment in the short run.
Now expectations are more than a number -- they are both a mean and a variance. The variance represents the degree of uncertainty about inflation expectations. Bernanke seems to say that variance of expectations is holding back the market -- thus the high degree of volatility that Isidore cites -- but that in this period there is not much the Fed can do about that. It can't do much about China or Iraq. It may make more sense for market participants to do their own calculations.

One response to this viewpoint would be that the Fed could fix things by adhering to a better anchor for price stability (like a gold standard.) But I find it hard to think fixed exchange rates or a fixed growth rate of the money supply would provide any help at this time. These are real supply shocks we face, not your run-of-the-mill demand displacements. Another response is that true inflation targeting countries rely on some information: there is an inflation report that inflation-targeting countries give to the public that contains the inflation forecast for the upcoming year. (See this description of the Bank of England's experience, for example.) Yes, Bernanke might reply, but firms need a proper framework with which to digest the information.

Thus the infamous comments to Bartiromo make a great deal of sense. And where Daniel Gross thinks the Fed is "flying by the seat of its pants", one might say instead that investors are working without a model, and it isn't Bernanke's job to remove any incentive for them to build one. Much better than the Greenspan world in which the numbers meant nothing until Alan told you what they meant.