Why Running the Fed is Art and Science

The Journal of Turkish Weekly (JTW) probably doesn't make your weekly reading list, or mine, but I couldn't resist commenting on this article written by one of my former professors about another. It's worth wondering why it is so hard for even sophisticated thinkers with billions at stake to settle on what the Fed will do next. Former Chief Economist at the IMF Ken Rogoff offers a brief, clear statement on why central banking and 'real life' macroeconomics is so important and tough. Chairman Bernanke's thinking on a crisis just like our current one isn't really a mystery to anyone, but how he will choose to steer the economy now that his hands are at the big wheel is. Rogoff rightly points out that the academic literature suggests a steady hand most times asset prices fall sharply.

On the surface, Bernanke’s view seems intellectually unassailable. Central bankers cannot explain equity or housing prices and their movements any better than investors can. And Bernanke knows as well as anyone that none of the vast academic literature suggests a large role for asset prices in setting monetary policy, except in the face of extraordinary shocks that influence output and inflation, such as the Great Depression of the 1930’s.

On the other hand, (as we economists are infamous for saying) reading the economy is no simple trick. I'm not saying we all sit around reading tea leaves, but that may not be as much of a stretch as you think. Even for an Academic superstar with an army of SAT-crushers to do his bidding, knowing where the economy has been can be tough; knowing just where it is now and will be tomorrow can be Everest.

But, while Bernanke’s view is theoretically rigorous, reality is not. One problem is that academic models assume that central banks actually know what output and inflation are in real time. In fact, central banks typically only have very fuzzy measures. Just a month ago, for example, the US statistical authorities significantly downgraded their estimate of national output for 2004!

Even if, like Chairman Bernanke, you are true to your academic convictions and have the mettle to risk being unpopular, the nature of beast offers no simple solutions. We can and do 'science' our way to a set of reasonable decisions but it's still 'art' that finally pulls the levers. Thinking about both the art, and a bit about the science, is what fills the Wall Street Journal, countless Bloomberg screens and makes bank for an endless supply of pundits.

For the rest, follow this link http://www.turkishweekly.net/news.php?id=48432.