Bernanke's Programs May Dilute Greenspan's Intuitions

Inside the U.S. Federal Reserveheadquarters, a small team is testing a forecasting program thatdoes the work of hundreds of economists. Never before has the Fedbeen able to crunch in real time such a large mountain of data --as many as 150 indicators -- to divine where the economy isheaded. Chairman Ben S. Bernanke is pushing the ``factor model''program -- so named because it reduces everything from home salesto mining capacity into a few weighted averages for makingpredictions. The Fed could use the help: Its gross domesticproduct forecasts, which influence its interest rate decisions,have missed the mark by an average of 1 percentage point since2000. ``It's a powerful tool that can potentially improve theFed's forecasts,'' says Richard Clarida, a global strategicadviser at Pacific Investment Management Co. and ColumbiaUniversity economist who developed a factor model as an assistantTreasury secretary in 2001. ``Forecasting, especially in realtime, is a challenge, and these programs are not swayed by theemotions or the conventional wisdom of the moment.'' Bernanke called the models ``especially promising'' in aspeech in 2004. He should know. In 2000, as an economist atPrinceton University, Bernanke created one that examined 78economic indicators. He found that its short-term inflation andunemployment predictions were about as accurate as those producedby some 200 economists at the Fed, according to his publishedpaper.

Human Superiority

``That was widely regarded as a successful piece ofempirical work,'' says Princeton economist Mark Watson, a pioneerin the field. Bernanke, 52, also found that computers have their limits.As part of his research at Princeton, he ran a program to seewhat would have happened if a computer had set monetary policyfrom 1987 to '98. Forecasts from Bernanke's factor model were fed into theprogram, which adjusted rates based on certain rules. The result:Inflation and unemployment fluctuated by larger amounts than inreal life, proof that Fed officials are better than software atmaking calls on interest rates. ``We find this evidence for human superiority comforting,''Bernanke wrote. Columbia professor Edmund Phelps, winner of the 2006 NobelMemorial Prize in Economic Sciences, agrees. ``There's going tobe a huge element of uncertainty left that is not captured by thecomputer models,'' Phelps says. ``Now is a time when therehappens to be an unusual amount of uncertainty.''

Betting Against Recession

In February 2006, when Bernanke became Fed chairman, theeconomy was speeding ahead, expanding at a 5.6 percent annualpace, and inflation was holding steady. He gained credibility byhalting the two-year run of interest rate hikes in August asgrowth started to slow. Now, he faces a more daunting set offacts: A plummeting housing market has raised the specter of arecession while inflation has nudged up. Economists aren't providing much clarity. Their predictionsfor 2007 are sharply divided compared with their earlier callsfor 2006. JPMorgan Chase & Co. argues that inflation will spurbenchmark rate increases up to 6 percent. Goldman Sachs GroupInc., taking the opposite position, sees the distinct possibilityof a recession and rate cuts to 4 percent. According to themedian forecast of economists in an October-November BloombergNews survey, officials will lower rates by half a percentagepoint to 4.75 percent in 2007.

Worst Over?

The Fed is betting against a recession even after theeconomy expanded at an estimated pace of 1.6 percent in the thirdquarter. The central bank has held its rate at 5.25 percent sinceJune, hoping that growth is slowing just enough to bringinflation down to about 2 percent or lower. The drop in crude oil prices from July's peak of $78.40 abarrel and higher stock prices may provide a cushion for theeconomy, says former Fed Governor Laurence Meyer, now vicechairman of St. Louis-based Macroeconomic Advisers LLC. ``Theworst may be behind us,'' concurs New York-based Neal Soss, chiefeconomist at Credit Suisse Group. ``Consumer outlays have beenvery strong.'' Housing is a dark cloud in the calculations of othereconomists. Goldman Sachs says a recession is increasingly likelybecause this housing slump is worse than the last two, in 1995and 1998-2000. New single-family home sales fell 23 percent inthe third quarter, and the housing market has yet to hit bottom,says David Rosenberg, chief North America economist at MerrillLynch & Co. ``The chance of a recession is a coin flip rightnow,'' Rosenberg says.

Hard Time

The Fed isn't any better at GDP predictions than privateeconomists, though it does outperform them on inflation,according to research by the Federal Reserve Bank of St. Louis.``Economists have a hard time forecasting turning points,'' Fedeconomist William Gavin says. Factor models, which run on a basic desktop computer, mayhelp officials with those twists and turns in GDP, inflation andemployment. ``It makes it easier to see margins on which we couldimprove our reading on the ongoing state of the economy,'' saysJeffrey Fuhrer, research director at the Federal Reserve Bank ofBoston. The models emulate in a way how Bernanke's predecessor, AlanGreenspan, discerned economic trends from reams of data, saysPrinceton's Watson. ``Greenspan was someone who had greatintuition and understanding about the economy,'' Watson says. The central bank won't say when its factor model will beused to help set policy. For now, Bernanke will have to rely onhis old tool kit to try to avert runaway inflation or recession-- whatever the case may be.