Another reason why economics is hard
When the Federal Reserve changes interest rates, the stock market often
reacts drastically in one direction or another. An accurate prediction
of the Fed’s actions can thus be a huge advantage for investors – and so
all eyes are on Alan Greenspan and the economy prior to FOMC meetings.
(It turns out that the recent move – a 25 basis
point increase – was pretty much anticipated and hence there was little
movement in the stock market).
One of the more bizarre methods of interest rate forecasting focuses
on the size of Greenspan’s briefcase – a thick briefcase on the morning
of the FOMC signals a change in interest rates. The logic is that the additional
evidence is needed to present to the committee a change in policy is necessary.
I think it was CNBC, the cable TV channel with financial news during
the day, that first popularized this indicator. (My favorite quote about
CNBC is from a friend who, the first time she saw the pre-market broadcast,
said “Do they know they’re on TV?”)
What does the briefcase really tell us?
So let’s say that CNBC was right and they found that a thicker briefcase
did indeed signal a change in interest rates. The first thing that would
happen is that you would find an even bigger horde of cameras and reporters
analyzing the briefcase when Greenspan walked to the office in the morning.
The next thing you would find is that there would be a stock market reaction,
which would take place as soon as Greenspan got into camera range and the
markets learned of the size of the briefcase.
If this were all that happened, then economics would be easy – we would
have a good way to predict an economic even based on a nice, easily observed
signal. However, there is an obvious problem with this: Greenspan almost
certainly knows that he is being watched. I’m sure that by now Greenspan
has been told that cameras are zooming in on his briefcase.
So, if Greenspan want to signal higher rates, he may throw a coupe of
magazines in the case to bulk it up a bit. But of course we’re no dummies
– we know that Greenspan may be trying to trick us…, and Greenspan knows
that we know…
Given all of this game playing, what does, or, better yet, what will
the briefcase really tell us? If you can figure it out let me know.
Why Economics is hard…
So here’s why economic is hard – we are trying to study people, and
people tend to react in intelligent ways: they may change behavior if they
are being watched, and they tend to act and think strategically.
The Greenspan example is very simplistic, but illustrative of a wider
range of economic phenomenon: as soon as we learn something about the economy,
and try to use that knowledge to our advantage, what we have learned may
no longer be true.
Another example – what would happen if we learn that every third Tuesday
stock prices rose by 20%? Everyone would then try to by on every third
Wednesday and sell on the Thursday – which would then cause prices on Thursday
to no longer rise by 20%.
…but not impossible.
Fortunately people are sometimes predictable, and we can indeed learn
something about the economy. We might have to be clever to find out how
things work, but there do seem to be some regularities that persist over
law for example).
However, I wouldn’t put too much stock in the briefcase indicator in
the future. Pun intended.
Links From the Web
1 basic point is 0.01%. So a 50 basic point rise is the same as a 0.5%
rise in interest rates. (e.g. from 5.5% to 6.0%).
The institution that is charged with enacting monetary policy and/or
regulating/facilitating the operation of the banking system. Sometimes
called a “bank’s bank”. The Federal Reserve is the central bank of the
The rate of interest that private banks pay for loans from the Federal
Short for Federal Reserve. To be more precise, monetary policy decisions
are made at the “Board of Governors of the Federal Reserve System” located
in Washington D.C.
Federal Open Market Committee (FOMC)
The committee that decides on the course of monetary policy. Composed
of the 7 members of the Board of Governors and 5 of the 12 presidents of
the member banks.
Decisions by the government about the level of government spending
The current Chairman of the Board of Governors of the Fed and the FOMC
The branches of the Federal Reserve System, which are located in each
of the 12 Federal Reserve Districts.
Decisions by the government (usually the central bank) about the supply
of money (and hence interest rates).