Posted by John Irons at February 04, 2000 02:30 PM
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 time (Okun’s law for example).

However, I wouldn’t put too much stock in the briefcase indicator in the future. Pun intended.

Links From the Web

Federal Reserve Board
Greenspan’s bio.
Cnnfn on the Briefcase Indicator

Basis point
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%).

Central Bank
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 US.

Discount rate
The rate of interest that private banks pay for loans from the Federal Reserve.

The Fed
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.

Fiscal Policy
Decisions by the government about the level of government spending and taxation.

Greenspan, Alan
The current Chairman of the Board of Governors of the Fed and the FOMC

Member Banks
The branches of the Federal Reserve System, which are located in each of the 12 Federal Reserve Districts.

Monetary Policy
Decisions by the government (usually the central bank) about the supply of money (and hence interest rates). Posted by John Irons at February 04, 2000 02:30 PM