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A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.

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Bernanke: Watch Cycle Indicators


Regardless of the change at the top, the Federal Reserve's main mission remains to nip inflation in the bud by stopping tight resource markets from translating into upward pressure on prices.

In doing so, the Fed can't wait for contemporaneous indicators like the unemployment rate and the capacity utilization rate to signal tightness - it would run the risk of falling hopelessly behind the inflationary curve given that the unemployment rate, for one, is classified as a lagging indicator.

To keep policy pre-emptive, the Federal Reserve monitors closely several types of cyclical indicators, such as the Economic Cycle Research Institute's index of inflationary pressures. And though this index is currently emitting an ambiguous signal, the overall picture it paints is one of moderation in the months ahead.

"Our future inflation gauge has taken two steps in the right direction (in November and December), but then took a mis-step in January," said Lakshman Achuthan, managing director at New York-based ECRI.

In fact, the future inflation gauge hit a five-and-a-half-year high in October and had climbed 11.3% from the low point in December 2003. But the index slipped in the next two months before making a partial recovery in January, although it is still 1.4% below the October peak.

"It is too soon to say that a cyclical downswing in underlying inflation pressures has begun," said Achuthan. He points out that a signal has to be pronounced, pervasive and persistent to be a valid leading indicator and, so far, the downturn in the future inflation gauge hasn't been persistent enough to signal a turning point. "If we get three declines in a row, however, it could be persistent enough to indicate an inflation downturn."

Paying Attention To Cycles

Fed policymakers keep a close eye on cyclical research - several have mentioned the ECRI index in speeches and former chairman Alan Greenspan, renowned for his ability to soak up economic data, is a former student of Geoffrey Moore, ECRI's founder, and likely follows ECRI's leading indexes.

Vice Chairman Roger Ferguson, also a student of the business cycle, cited ECRI in a paper he gave at the Stanford Research Institute just over a year ago, with the title: "Recessions and Recoveries Associated with Asset-Price Movements: What Do We Know?".

New Fed Chairman Ben Bernanke is also a student of business cycles - he wrote his dissertation on the Great Depression, the most violent U.S. business cycle of the 20th century.

Achuthan notes that "the future inflation gauge adds up and summarizes the key drivers of inflation; it's not just a simple cause and effect. Putting all the drivers together" is what makes this gauge a powerful tool, he said.

As to the current cycle, the indicators that Achuthan and his colleagues at ECRI are scrutinizing lead to the conclusion that the economy is in a moderating phase.

The ECRI analysts are not overly concerned by the signs in the January jobs report, released Friday, that labor earnings are being pushed up as a result of the tightness in the labor market. In fact, he maintains that wage growth is "a pretty bad leading indicator of inflation, it actually lags a prior pickup in inflation." ...

Indeed, the ECRI outlook, which is the result of a coordinated analysis of a number of short- and long-leading indexes of U.S. and global economic activity and inflation, is pretty benign: a resilient economy in the first half of the year, some hope of light at the end of the tunnel on inflation so that "any scenario of run-away inflation has low probability and any scenario of recession is also low."

If, in fact, the Fed is looking at these types of leading indicators, they may be getting ready to relax a bit. Achuthan points to the willingness of the Fed under Greenspan to accommodate growth in 1996-98 when the jobless rate was drifting down through the 5% level and the fed funds rate was held in a 5% to 5.5% range...