The New Two-Handed Monetary Policy Indicator

The economy, financial markets, and monetary policy have come upon difficult times. The credit crisis that began erupting around midyear 2007 was followed by slowing economic growth, rising unemployment, and increasingly trying times for earnings for a wide variety of companies, especially in financial services.

I was writing a recent economic update and reading the latest available Federal Open Market Committee meeting minutes to try and get a grip on things when I noticed something interesting: There seemed to be a lot of "howevers" in there. Then it struck me that perhaps it wasn't that odd to see so many "howevers" in the minutes lately, given the heightened stress policy makers are likely experiencing.

So I set out on a search for the next great monetary policy indicator. I pulled all the FOMC minutes from the beginning of 2007 to the most recent meeting and counted the number of times the word "however" appeared. It took about 10 minutes. The results were striking.

During the first half of 2007, as the credit market bubble had yet to burst and the economy seemingly was plodding along at a comfortable rate, the number of "howevers" in the FOMC minutes declined. They fell to five in the minutes prepared after the June 27-28, 2007 meeting. This was the meeting right before the onset of the credit crisis in July 2007. Then they embarked on a steady but significant climb, reaching 18 in the minutes for the latest meeting for which minutes are available (March 18, 2008).

The long train ride upward coincides with a rising unemployment rate over the last year, as well as heightened inflation.

 

Faced with a slowing economy and rising uncertainty in credit markets, the FOMC has moved the federal funds rate, its principal monetary policy instrument, significantly lower in the last year, even as the consumer price index inflation rate has been rising. The next chart shows the number of "howevers" in the minutes along with the fed funds rate (inverted) immediately after those FOMC meetings, which appears to provide a striking correlation:

The MPI�Not a Leading Indicator, and Probably Not Worth Looking at Again
The pattern in the number of "howevers" in the past year and a half could just be a random pattern, and the correlations with important macroeconomic variables could really just be spurious.

But the past year has certainly been a period of growing stress in the credit markets and also for monetary policy makers. Anybody charged by law with the mandate to pursue both stable prices and maximum employment must be getting more stressed out as unemployment and inflation are rising simultaneously. In turn, the pursuit of maximum employment may work at odds with the pursuit of price stability, and vice versa, at least in the short run. It seems reasonable to conclude that the "however" factor is operating for good reason.

But the "however" index is not a good leading indicator, and it probably doesn't make much sense to pay close attention to this in the future. First, it's worth noting that the "howevers" were declining before the credit market crisis erupted, and then started increasing as that crisis intensified, the broader economy slowed, and inflation accelerated. Second, the dates used in the charts above for the unemployment rate and the CPI inflation rate were the latest available and had already been reported at the time of each FOMC meeting. Third, the FOMC minutes are still released with a lag after each meeting. Finally, in a mirror image of the cautionary notes arising from the "rational expectations" school of economic policy, which cautions that a rational public may change its behavior when confronted with new information about the behavior of economic policy makers, the people who prepare the FOMC minutes may change their writing behavior if this article gets widely read.

In turn, we can't make a lot of stock calls or other valuable stock investing recommendations on the basis of this finding, if it is a finding at all. But we still think it is an illuminating way of illustrating recent economic trends and thinking about how monetary policy is constructed.

It also provides some lessons. Evidently, the priests in the high temple can be as flabbergasted as the rest of us sometimes. On the one hand, this may be comforting. On the other hand, however, it may be a bit stressful to note that 12 people deciding the correct amount of money and credit for 300 million other people can behave in a backward-looking, reactive, and confused way, just like other normal human beings.