A pedestrian walks past the Marriner S. Eccles Federal Reserve building in Washington, D.C., U.S. (Photographer: Andrew Harrer/Bloomberg)

Why the Fed Should Try to ‘Feel the Market’

(Bloomberg Opinion) -- President Donald Trump, or rather @realdonaldtrump, was at it again Tuesday morning. He tweeted his displeasure at the current state of financial markets and the prospect of an additional rate hike by the Fed at this week’s meeting:

As is often the case, the president’s histrionics contain a sliver of truth. Trump pleaded with the Federal Reserve to “feel the market, don’t just go by meaningless numbers.” That sounds insane. Economists are nothing if not obsessed with numbers, and the Fed, in particular, is a data-driven institution that has become only more so under current Chairman Jerome Powell.

Still, even the most astute Fed watchers realize that the Fed has an implicit “financial stability” metric: It is aware that hard economic data paint only part of the picture. The financial markets can affect how the economy evolves.

If anything, this is an understatement. When it comes to forecasting recessions, hard economic data is of little use. Two years ago, Fed economists looked at which measures did the best job of forecasting recessions. They came up with five:

  • The change in payrolls, basically the monthly jobs report
  • The TED spread, a measure of financial stress
  • The change in initial claims for unemployment insurance
  • The slope of the yield curve
  • The GZ index, a measure of credit risk developed by economists Simon Gilchrist and Egon Zakrajsek

The first three can indicate with near certainty whether a recession has already begun. For forecasting, the last two are of more use, and both are measures of financial conditions rather than straightforward economic data. Lately there has been a lot of attention paid to the yield curve.

The GZ index is a more recently developed measure that attempts to measure the credit spread across a wide variety of U.S. corporate bonds. The credit spread is the difference between what U.S. corporations have to pay to borrow money and what the U.S. government has to pay. What makes the GZ index unique is that it captures what its creators refer to as the “excess bond premium.”

Corporations have to pay a higher interest rate on their bonds than the U.S. government for two reasons. First, they are more likely to default. But even after accounting for this risk, there is still a difference in interest rates paid by corporate bonds and Treasuries. This is the excess bond premium, and it provides a sense of investor sentiment.

On its own, this measurement of the excess bond premium does a reasonably good job at predicting recessions. The most notable false positive was in 2002, when a wave of corporate accounting scandals sent the excess bond premium soaring but the economy avoided entering a recession. A combination of the yield curve and the excess bond premium, however, is the best recession forecasting metric that economists have.

The Fed may like to talk about hard economic data when explaining its economic outlook. But the Fed’s own analysis shows that market sentiment is a more reliable indicator of where the economy is headed. In other words: When making decisions about interest rates, maybe it’s not such a bad idea for the Fed to take into account how the market feels.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Karl W. Smith is a senior fellow at the Niskanen Center and founder of the blog Modeled Behavior.

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