John Irons's Blog


Economic News, Data and Analysis

Exploring the Gap

Federal Reserve Board

Say you’re a reporter on your way to interview Alan
for a story on the current economic climate. As you walk
into the old-style government building on 20th and C Streets
in northwest Washington D.C., you encounter a two-story tall open entranceway.
A pair of yellow-white marble staircases lead up along the side walls,
past the offices of the board members, and to the second floor entrance
of the grand “board room” in which the path of the economy is charted by
Alan Greenspan and crew (via the FOMC
). Just beyond the board room is Greenspan’s office.

Say, for the moment, that you pass on the staircases and decide instead
to take the elevators just to your right. While you wait, you wander into
a small room on the opposite side of the corridor. On the walls behind
glass hang sample dollar bills (just in case you are not familiar with
your own country’s currency) and glossy images of documents and pictures
relating to the Fed’s history and mission – interesting probably only to
monetary economists and historians.

However, next to the entrance is a waist high TV monitor with the kind
of low resolution graphics that immediately suggests an interactive computer
is waiting for a signal from its touch-sensitive screen to bring it to
life. Indeed, your finger on the screen lights up the machine, which then
promptly asks if you’d like to play the role of the Board Chairman in managing
the economy. The elevator hasn’t arrived yet, so you answer “yes”.

What follows is an economic senario: the economy is booming, unemployment
is low and inflation is rising do you: a) lower interest rates, b) keep
interest rates unchanged, or c) raise interest rates. Remembering the articles
you’ve read in the Wall Street Journal
and your economics 101 you hit “c”. “Correct!”, you are congratulated by
the computer. After a couple more questions and correct answers, you feel
like asking Greenspan, “Hey what’s the big deal, this job doesn’t seem
so hard!”

So what’s the big deal about monetary policy? If the economy is moving
too fast and inflation is rising – step on the brakes by raising interest
rates. If it’s moving too slow with low inflation and high unemployment
– step on the gas by lowering the interest rates. Of course, different
people will have different opinions about how much we should fear inflation
relative to unemployment – but once you have a goal in mind then just follow
the computer simulation in the hallway, right?

Not so fast.

The problem with this line of thought is that we know very little about
1) what is possible in the economy, and 2) how the economy will react to
the changes in monetary policy. When we are unsure about where the economy
is (or can be) as well as the precise way to get there we enter a world
in which experimentation is the key to good policy.

As an example, economists and economic journalists will often refer
a beast called the NAIRU — many claim it is a mythical beast — which
stands for “Non-Accelerating Inflation Rate of Unemployment” (if you say
it slowly it makes more sense) — it also known as the “Natural Rate” of
unemployment. It refers to a level of unemployment that will not lead to
increasing inflation. So, if you are the Fed and don’t want inflation to
rise, you will try to get the economy to reach the NAIRU – but no lower,
else inflation will take off.

However, the Fed, like the rest of us, doesn’t have an exact measure
of the NAIRU. Nor does it know exactly how much to change interest rates
(both now and in the future) in order to achieve the NAIRU even if it were
known (or even known to exist for sure). To make things even worse,
the economy is always changing – so even if you had a good idea how things
worked today, your knowledge would quickly become outdated. The following
quote by Alan Greenspan illustrates this lack of knowledge:

“I wish it were possible to lay out in advance exactly what conditions
have to prevail to portend a buildup of inflation pressures or inflationary
psychology. However, the circumstances that have been associated with increasing
inflation in the past have not followed a single pattern. The processes
have differed from cycle to cycle, and what may have been a useful leading
indicator in one instance has given off misleading signals in another.”
Alan Greenspan, Humphrey-Hawkins
, Feb 26, 1997.


So, are the policymakers really just groping in the dark? In a sense yes,
but hopefully with a flashlight. They do gather, chart, and analyze as
much information as possible – but there are still gaps in what we know
about the mechanisms of the economy. The best solution to managing a partially
unknown and changing economy is to experiment. Try a little of this, try
a little of that. Try not raising interest rates when the economy is cooking
along. Many observers have been trying to get Greenspan to “explore the
gap” – see how fast we can get growth to go before inflation kicks up –
maybe the recent holding steady of interest rates is the Fed’s most recent

The stakes in this kind of experiment are high, so we want to make sure
that we learn as much as possible from the experiments that are made. The
best way to insure policy failure in a changing environment is to always
do the same thing. Only experimentation will keep policy close to success.

Perhaps a good question for your interview with Mr. Greenspan is “What
do you expect to learn from this next experiment?”

Historical Interest Rates.

Source: FRB
Historical Series

See Also:

Filed under: Economics

Economic Assumptions and the Balanced Budget Agreement

Is the much hyped “budget agreement” of 1997 breaking down? Will the
verbal agreement to balance the budget by 2002 survive the budgeting process
or will another standoff result in another shutdown of Yosemite and the
rest of the Federal Government?

Whether or not the budget resolution gets through the process, the balanced
budget cause was certainly helped along by a favorable economic picture.

Economic Assumptions

The economic assumptions used by the various budgeting agencies play an
important role in determining the feasibility of budget proposals. The
recent strong upsurge in the economy (unemployment under 5%, GDP
at 5.6%, inflation
under 3%) has given the political actors some room for maneuvering – perhaps
even enough to reach an agreement on a path to a balanced budget by 2002

When projecting the deficit into the distant future, the assumptions
used to estimate the size of the private economy play an extremely important
role. The higher the rate of growth in the economy the greater are federal
tax revenues and the lighter is the burden on social “backstop” programs
like welfare and unemployment insurance. As the rate of growth compounds
year after year the estimates of the debt responds in kind.

The Whitehouse‘s Office
of Management and Budget
(OMB) and the Congressional
Budget Office
(CBO) each produce a set of forecasts which are then
used to project the deficit. Each of the forecasts are given in the table

We must also admit that there is quite a large margin of error when
we are looking five years out into the economic future. While each of the
forecasts from the different agencies can be compared with each other,
(the CBO is more conservative on most measures, but the OMB seems to have
been a more accurate forecaster recently), the end result is really that
the forecasts are roughly equivalent.

The thought that  we should aim for exactly a zero deficit
in exactly the year 2002 seems slightly misguided once we admit
to the uncertainty of our forecasts. It’s good to have goals – but bickering
over small budget items should not overlook this fact.


Projections: 1997 1998 1999 2000 2001 2002
Real GDP Growth            
   CBO 2.1 2.1 2.2 2.2 2.1 2.1
   OMB 2.0 2.0 2.3 2.3 2.3 2.3
   CBO 2.9 3.0 3.0 3.0 3.0 3.0
   OMB 2.6 2.7 2.7 2.7 2.7 2.7
   CBO 5.3 5.6 5.8 5.9 6.0 6.0
   OMB 5.3 5.5 5.5 5.5 5.5 5.5
Interest Rates            
  10 year T-bill            
   CBO 6.2 6.1 5.8 5.5 5.5 5.5
   OMB 6.1 5.9 5.5 5.3 5.1 5.1

Source: FY1998 Budget.

See Also:

  • Take the budget quiz at the Third Millennium
    to see how well you know the 1995 budget.

  • What would you do if given control of the budget for the next five years?
    You can simulate your own budgetary changes at the CCER
    National Budget Simulation

Filed under: Economics