The Popular Sport of Fed Watching
Economists have monitored actions by the Federal Reserve for many years. The field became particularly lucrative in the late 1970s. Before then, Fed chairmen had come and gone but few became household names like Paul Volcker or Alan Greenspan. Volcker made a radical announcement in October 1979 that the Fed would target monetary aggregates (such as M1 and M2) instead of targeting the federal funds rate. Fedwatchers who estimated the daily reserve needs of the financial system became the most sought-after economists by banks and investment firms. Fed watching was glamorous.

In the mid-1980s, the estimation of daily reserve needs and forecasts of M1 and M2 were still duties among Fed-watching economists. But since the Fed was no longer directly targeting monetary aggregates, following economic indicators gained stature instead. President Reagan appointed Alan Greenspan as Fed chair in August 1987. This marks the beginning of the modern era. Fedwatchers who only knew how to measure reserve needs or how to estimate weekly monetary aggregates were pushed to the rear by "real" economists, that is those who monitored the real (non-financial) side of the economy. Economic indicators became king.

Indicators followed by the Fed … Indicators followed by the Fed’s Chairman
The Federal Reserve has generally followed the same goals throughout its history: "… to promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates."

By definition, then, indicators that reveal inflation become important ones to follow. Federal Reserve policy-makers have long monitored the consumer price index (CPI) and the producer price index (PPI). They have also followed commodity prices. The Fed watches the monthly employment report because it reveals labor market conditions. The Fed clearly is concerned with economic growth and follows trends in gross domestic product (GDP). When we come down to the nitty gritty, Fed policy makers have long followed most of the economic indicators that are current financial market favorites.

But the arrival of Alan Greenspan to the hallowed halls of the Federal Reserve brought attention to precise and detailed monitoring of economic indicators. Early on, financial market participants learned that the NAPM was a Greenspan favorite. It had not been a major market-moving indicator until 1987 when Greenspan said he watched the report’s supplier delivery component. The Great Crash revealed another Greenspan favorite: consumer confidence surveys.

Fast forward to the 1990s and Greenspan revealed his favorite labor market indicators. For instance, he regularly monitored the quit rate in the mid-1990s when the unemployment rate was approaching 5.8 percent. At the same time, a greater significance was attached to the employment cost index.

Getting inside Greenspan’s head
Let’s look at some of the indicators widely seen as Greenspan’s favorites, along with those we have found to be key indicators.

Inflation
Only the Fed can control long-term price stability. The inflation indicators, in a sense, are obvious. The most common of all is the consumer price index. The reliability of this indicator has been questioned in the past few years as policy-makers have attempted to reduce increases in entitlements – which are contractually tied to the CPI. The Boskin Commission reported in 1996 that the CPI overstated the "true" inflation rate by at least one percentage point, but possibly by as much as 1-½ percentage points. The Bureau of Labor Statistics conducts ongoing research to improve measurement of inflation. Several improvements were introduced in 1998 and 1999 in order to reduce the overstatement of inflation in the CPI.

Nonetheless, Greenspan has traditionally preferred the price index for personal consumption expenditures (PCE), a preference he repeated again in his January speech before the Economics Club of New York. The PCE is available monthly and quarterly as part of the GDP report. Unlike the CPI, which is a fixed basket of goods, the PCE deflator allows consumers to substitute alternative goods that are lower priced. The trends are likely to be the same. The chart above compares year-over-year changes in the two measures. Both are rising on a year-over-year basis, but the PCE deflator is increasing about ½ point less than the CPI since 1998.

The employment cost index remains an important measure of inflation in the labor markets. The idea here is that accelerating compensation costs leads to consumer price inflation as companies try to offset labor costs by increasing the prices of the goods and services they produce. This index tends to be most consistent when looked at on a year-over-year basis, smoothing out quarterly fluctuations.

Gold prices have often been considered an inflation-hedge and they have been relatively stable through much of this inflation-friendly business cycle. Prices began a sharp downward slide as Southeast Asian economies tumbled. In 1999, many central banks either announced their intentions to sell gold reserves or actually sold gold reserves (such as the Bank of England). However, analysts who monitor prices and production say the central bank sales are just a drop in the bucket compared with the metal’s total supply, making them an unlikely suspect for the price drop. In his congressional testimony in June 1999, Greenspan indicated his belief that the drop in gold prices reflects a favorable overall long-term outlook on inflation.

Financial Markets
Fed policy-makers all follow stock and bond markets very closely though by mandate market management is not the central goal of policy. Greenspan made his feelings known about the stock market when he made his "irrational exuberance" remark several years – and several thousand points -- ago. There is no question that market levels and market activity affect consumer and business behavior. The long-term bull market in equities created a consumer shopping frenzy. Consumers spend considerably more than they earn when they feel "wealthier" from the unrealized gains in their portfolios.

Behavior in the bond market is also relevant. When interest rates are rising, the cost of borrowing increases. Higher mortgage rates reduce affordability and housing construction. Higher interest rates also reduce business spending. Conversely, a low interest rate environment points to a booming economy, as we saw earlier this cycle. Policy-makers raised rates three times in 1999 in order to curtail the housing market and related industries.

Economic Growth
The civilian unemployment rate indicates the utilization of the nation’s labor resources. When the unemployment rate is high, workers are not likely to demand higher wages because they are happy to have jobs. When the unemployment rate decreases sharply, employees are more likely to expect wage gains – or find another employer who will give better wages, salaries and benefits. The lower the unemployment rate, the more difficult it is to maintain price stability because higher wages eventually lead to higher consumer prices (or so the theory goes).

The unemployment rate depends on the number of unemployed persons in the labor force. Not everyone in the population is actively looking for employment – and thus the labor force is changeable. The pool of available labor is a more comprehensive figure, which also considers those not currently in the labor force but who might like to work. Incidentally, more people are willing to work when the going wage rate is higher. Indeed, Greenspan & Company also monitor closely the pool of available workers, released monthly with the employment report.

An economy benefits from productivity increases because it allows greater production capacity with no additional increases in labor. The standard of living increases because wage earners get increased wages that are not inflationary. Productivity trends have been favorable in the 1990s. Though Greenspan believes the trend could be favorable for a long period of time, he warns the growth rate of productivity may slow down. This would make it more difficult to see higher wages without higher prices.

The Bottom Line
Fed watching used to be a sport for economists who translated fed-speak for financial market players. Now, more individual investors follow economic trends along with daily (and hourly) changes in stock and bond prices. Individual investors are more inclined to make their own assessments of comments by Fed chairman Alan Greenspan.

The Fed chairman has brought greater transparency to Fed actions. But when the institutional framework was traditionally one with virtually no transparency, the relative term ‘greater’ is misleading. Greenspan and fellow members of the FOMC often give their views on economic conditions, inflation, and the potential for Fed policy changes. But for the most part, their explanations (along with Greenspan’s) are as clear as mud.

Do follow the Greenspan cadre of indicators. Do pay attention to the chairman’s remarks. But the chances of understanding him are 50/50 at best. Even when he tells us the indicators he monitors, you know that there are many more indicators actually on his screen. And then … there is always "anecdotal evidence".

Fed-watching frenzy increases in direct proportion to the timing of the next FOMC meeting. The closer we are to a meeting, the more skittish market professionals are about each and every indicator. Beware. Daily indicator announcements, which reveal different angles of the economy, will no doubt shift the balance of expectations on Fed policy as frequently as individuals now follow stocks … daily or even hourly.