Federal Reserve struggles to predict economy after recession

WASHINGTON — Chairman Ben Bernanke and his Federal Reserve colleagues are preparing to meet today as two-year Treasury yields at a record low signal a U.S. economy on the knife's edge between growth and contraction.

Guiding their assessment of the outlook for the world's largest economy will be forecasts contained in the so-called Teal Book, a confidential staff report. Policymakers' confidence in those forecasts may be tempered as the course of the expansion has confounded their expectations.

Of 12 Fed staff forecasts since the start of 2010, seven have been downward revisions to the near-term outlook, according to minutes of Federal Open Market Committee meetings. This year, the outlook was raised in January, but lowered three times since on a stream of data showing weakness in employment and consumer spending.

"We haven't had any historical event that really would allow us to reliably statistically calibrate an event like the one we've had," David Stockton, director of the Fed's Division of Research and Statistics who has overseen forecasting for a decade, said in June. "There isn't going to be a simple story here."

At their last meeting in June, Fed officials decided to keep the central bank's balance sheet at a record to spur the slowing economy after completing $600 billion of bond purchases.

In testimony to Congress last month, Bernanke signaled the central bank has more tools for easing should the economy weaken. "We have to keep all the options on the table," he said.

That testimony was followed by reports on industrial production, consumer spending and employment that were weaker than predicted by economists.

The suite of models used by the Fed staff to forecast changes in consumption and investment rely to some extent on past relationships between interest rates, income and profits. Most also assume credit will be supplied and demanded at a given price or interest rate. Without adjustments, they revert to the mean — after a period of slump they begin to point upward, in line with previous recoveries.

All of those tendencies have made the models less trusty guideposts for what is happening in the current recovery.

"Something new and different is going on," said Allen Sinai, chief global economist at Decision Economics in New York. "Neither monetary nor fiscal policy is giving us the kind of bang we have traditionally got. The household sector is simply not spending as it has in the past."

Nowhere have historical patterns gone more off the rails than in labor markets. Forty-four percent of the unemployed workers in the United States now have been without a job for 27 weeks or more, near the 45.6 percent peak in May 2010, the highest of any business cycle in the postwar period.

The persistence of high unemployment, a concern Bernanke has voiced on several occasions, ripples through the economy. A high jobless rate reinforces low income expectations and can result in an enduring trend of pessimism that makes consumer spending difficult to predict.

Ordinarily, monetary policy works by making borrowing cheaper so households and businesses can access credit and keep their consumption stable through an economic slump. Now, that channel is less effective.

Banks have raised lending standards, and the private sector's expectations about consumption may be shifting to a lower path, said Julia Coronado, chief economist for North America for BNP Paribas in New York, who worked for Stockton from 1997 to 2005.

"This is a standard-of-living shock," Coronado said. "What we thought we could afford, and what we leveraged to, is much more than we can afford at present and in the future."

Federal Reserve struggles to predict economy after recession 08/08/11 [Last modified: Monday, August 8, 2011 11:32pm]

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