My favorite epistemology guru, Donald Rumsfeld, taught us there are things we know, things we don’t know, things we know we don’t know and things we don’t know we don’t know.
This is intriguing material for a philosophy seminar, but is it any way to run an economy?
As the Federal Reserve, as widely expected, prepares to cut interest rates again on Wednesday, the answer apparently is yes.
Recent comments by Fed officials, including Chairman Ben Bernanke, indicate that the central bank plans to once again cut interest rates based on what it knows it doesn’t know, thereby opening the labyrinth of what the Fed doesn’t know it doesn’t know.
After its Aug. 7 meeting Fed officials said, “Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.”
But after the subsequent meeting, on Sept. 18, reference to “incoming information” was replaced by a statement that “developments in financial markets … have increased the uncertainty surrounding the economy outlook.”
Since no one knows the depth of losses looming over lenders and packagers of loan-based investment schemes, “the Fed took out an insurance policy against an extreme event happening,” said Stephen Wood, senior portfolio strategist at Russell Investment Group.
In his first speech on monetary policy since being named president of the Federal Reserve Bank of Chicago, Charles Evans described his point of view as follows: “It is prudent to adjust policy to be more or less accommodative than we otherwise would as insurance against the highly adverse outcome.”
In other words, a rate cut is intended to avoid a disaster, however unlikely, and it could be reversed if the threat eases. A benign outlook for inflation enables the Fed to make a pre-emptive strike against a worst-case scenario in financial markets, he added.
This approach to interest rate policy opens the Fed to criticism that it is using its power to bail out banks that made lax and abusive loans and sellers of investment products built from those loans.
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Of course, if we focus on things we don’t know, many disasters loom: gasoline at $10 a gallon, a free-fall in the dollar, a surge in the unemployment rate. What makes “developments in financial markets” so special?
Moreover, if the stock market presents any guide, the Fed’s September rate cut appears to have offered little comfort to financial firms and, instead, to have sparked 1990s-style exuberance in technology stocks.
“One must also take seriously the possibility that [Fed] policy actions that have the effect of reducing stress in financial markets may also promote excessive risk-taking and thus increase the probability of future crises,” Bernanke acknowledged in a recent speech.
The problem, said veteran Fed watcher David Resler, chief economist at Nomura Securities International, is that the Federal Reserve cannot wait until solid evidence of a recession is in hand before it cuts interest rates. By then, the action would be too late. The central bank’s task depends on its forecast, not just current knowledge, he said.
Nor is the Fed in the business of uttering self-fulfilling prophecies, he said.
The Fed’s recent expressions of concern about troubled financial markets may be an indirect way to warn of a threat of a broad downturn in the economy, Resler said.
He suggested the latest Fed rhetoric was a “head fake” intended to avoid scare talk about recession.
“I don’t think the Fed wants to talk about how weak things are getting. Let’s suppose that I were the Federal Reserve chairman and I wanted not to convey the sense that I thought the economy was slipping rapidly toward recession,” he said. “I’d characterize it by saying we’re aiming to head off a problem in the credit markets.”
So, we need to add something to the levels of knowledge: In addition to what we don’t know we don’t know, there’s what I know but you shouldn’t. I think Rumsfeld would approve.
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