The Number One Source of Uncertainty in the Economy

In addition to concerns about taxes, spending, and the fiscal cliff, the on-again, off-again nature of U.S. housing policy over the past four years has been a major source of economic uncertainty. But all of those factors pale in comparison to the uncertainty created by the Federal Reserve’s wait-and-see attitude toward monetary policy.

The Fed’s influence in generating uncertainty can be seen in news reports following every new batch of economic data. The stories always include analysts mentioning the Fed’s reaction to the news as their primary concern. For instance, take this Bloomberg News write-up of the data on retail sales that came out today:  

Benchmark 10-year note yields reached almost the highest level since May as the consumer-spending data and the Aug. 3 report of stronger-than-forecast jobs gains reduced speculation the Federal Reserve will add to its monetary stimulus. U.S. debt fell earlier after the German economy expanded in the second quarter at a faster pace than analysts forecast and the French economy unexpectedly avoided a contraction.

“Today’s data, combined with the employment report, makes it harder for the Fed to do another round of quantitative easing,” said Gary Pollack, who manages $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York.

Notice that the report immediately pivots from announcing the new data to speculating about how the Fed will act, and wondering if it will engage in a new round of bond-buying.

Understand what’s going on here: if a jobs, GDP, or other economic report shows good news, businesses are supposed to take that as a sign that demand and the economy are going up, and plan and invest accordingly. Instead, they guess at the report's effects on the Fed’s intentions. A good report could mean that the Fed will look at the new data and decide not to provide additional monetary stimulus, thereby undercutting the momentum that would otherwise come from a positive report.

Because the Fed’s decision is always looming in the background, investors are left uncertain about the meaning of any given economic indicator. Good news that should nudge businesses toward hiring new workers and investing in new capital instead provokes questions about whether the improved outlook means that the QE3 the Fed had lined up and ready to roll out at the next monetary policy meeting will be mothballed.  

The result is a vaguely ridiculous guessing game between the market and the Fed. Investors comb the data and past Fed statements for any possible hint of future action, while Chairman Ben Bernanke or another member of the Federal Open Markets Committee drops hints to journalists about the likelihood of a new stimulus program. The end result is that the Fed is constantly forestalling the recovery.

The Fed could end this game by instituting a rules-based monetary regime to replace the current discretionary one. That is, it could follow a rule that dictated its policy depending on certain economic indicators, as opposed to the whims of Bernanke & co. That rule could be what’s known as a Taylor Rule, named after the Stanford economist John Taylor, that was simply a function of the unemployment and inflation rates. Or it could be, as Bentley University economist Scott Sumner has recommended, a commitment to keeping total nominal spending growth on a steady growth path. It could even be as simple as a statement that the Fed will always buy bonds when inflation is running below 2 percent, and always sell them when it’s above.

Any of those options would remove the uncertainty that accompanies every jobs bill, GDP report, and manufacturing survey today. But for now, the market has to figure out whether or not the Fed will do something big when it meets again in mid-September.