How to Forecast the economy.(COMMENTARY)

Article excerpt


Knowing that I am an economist, friends and acquaintances frequently ask me, "What is going to happen with the economy?" If I say with great assurance, "Inflation will rise 0.3 percent, unemployment will fall 0.6 percent, and economic growth will increase by 3.2 percent," they will walk away happy, believing they know something others do not. Or, I can be honest and say, "I don't know with certainty, but the actions of the Federal Reserve and the Congress are likely to do X." (Asking an economist what the economy is going to do is a bit like asking your stockbroker which stocks are going to go up. If he knew, he would be living like Warren Buffet rather than pushing stocks to you.)

A major reason people are so confused about the future of the economy is that they are confronted with a huge amount of misinformation on a daily basis by all too many in the press, as well as an endless babble of ignorance and deliberate distortion oozing from the political class.

To clear up the confusion, the following is all you really need to know to make reasonable judgments about the future course of the economy.

Inflation - a rise in the general price level - is caused when the central bank (the Federal Reserve in the U.S.) produces too much money in relation to the volume of goods and services, and deflation - a fall in the general price level - is caused by too little money. The problem for the central bankers (e.g., Alan Greenspan) is that it is very difficult to know beforehand how much money to produce, because changes in tax and regulatory policies, government spending rates, technological innovations, terrorists' acts, and actions of other countries all affect the real growth rate of our economy.

Recently, the Fed has been producing a lot more money, but that has not, so far, resulted in inflation because the velocity of money (i.e., the number of times the same dollar is spent in a year) has fallen. Velocity is down because people are holding more of their money due to the rise of uncertainty resulting from terrorists' threats and concerns about the real financial health of many large companies.

Common price indices, such as the consumer price index, are not very helpful in guiding the Fed, because the indices only tell if too much or too little money was produced in the past. The best indication of future inflation or deflation is analysis of sensitive commodity prices, particularly "futures" prices. These indices can be found in the Wall Street Journal and other papers. Commodity prices are now slightly lower than they were both a decade ago and a year ago. Six months ago, they were quite depressed, but they rose steeply in late winter, primarily due to the increase in oil prices. In recent weeks, they have been slowly drifting downward, which means there is no immediate inflation threat.

Government regulations can cause the economy to slow when the costs of the regulation exceed the benefits. …