Fed Actions Are More Art Than Science Antiquated Research Methods Skew Diagnosis Of Economy

A good chef sharpens his knives. A good carpenter hones her awl. And a good economist … seems to live with the same dull tools of yesterday.

As the Federal Reserve showed Tuesday with its surprising decision to leave interest rates unchanged, the economy is giving off mixed and confusing signals. Many economists claimed they saw clear signs of inflation, and they predicted the Fed would move as usual to squelch it by raising the cost of loans, a step to slow the economy.

But the Fed looked at the same picture and decided otherwise. Its monetary policy makers may have had other motives for standing pat - speculation includes internal and presidential politics - but the decision revived a series of questions about the economy: Are we measuring it incorrectly? Is it healthier than the numbers show?

If the answer to those questions is yes, as a mix of economists across the political spectrum believe, the implications are big. It would mean that the economy can grow faster than economists thought without sparking inflation - creating more jobs and higher paychecks for millions of Americans.

Setting policy on interest rates is more art than science, and an odd combination of recent signals has made it less scientific than usual.

Housing is booming, but retail sales are down. Consumers report plans to spend money, but credit card debt is so high that many are going bankrupt. Unemployment is at a six-year low, but there are few signs that it has forced businesses to raise wages to attract workers and raise prices to offset the wages, as many economists predicted.

Adding to the uncertainty, many economists are challenging whether these economic trends are being measured accurately. “We can’t see inflation. It’s unobservable,” said Larry Hunter, chief economist with Empower America, the policy group led by Republican vice presidential candidate Jack Kemp. “Inflation is sort of like a quark. All you can observe are the traces it leaves.”

“I think the Fed is sitting down with the equivalent of a 10-key adding machine,” said Sen. Byron Dorgan, a North Dakota Democrat. Economic yardsticks designed for a manufacturing economy do not consider the impact of software, fax machines and other modern productivity-enhancing tools. “The whole thing has passed them by,” he said.

Alan Greenspan, the Fed chairman, expressed frustration with his economic indicators in testimony before Congress two years ago. “The list of shortcomings in US economic data is depressingly long,” he said.

Greenspan added: “Making inferences about the future is always harder when readings on the economy are contaminated by measurement error.”

Greenspan said measures of inflation are particularly error-prone, and a commission of economists confirmed his opinion last September. Headed by Michael Boskin of Stanford University, the commission concluded that the consumer price index overstates the rise in the cost of living by about 1.5 percentage points each year.

The price index measures the cost of a fixed basket of goods. According to the commission, it does not consider that products improve over time so buyers get more for their money, as anyone who has bought a personal computer lately would likely know. It does not adequately note that consumers might respond to a price increase for one product, like beef, by substituting a cheaper product, like chicken. It does not adequately factor in the impact of discount outlets like Wal-Mart.

Similarly, economists often measure productivity as worker output per hour. But newer measures include not only hours worked but the quality of their work and the capital employed, said Dale Jorgenson, a Harvard University economist.

Some economists challenge the way the government measures imports, exports, producer prices and other economic trends. Unemployment, for example, does not include people who have given up looking for a job. Because that group of people is thought to be growing, the unemployment number may understate the number of people without jobs.

But economists are split on the effect that mismeasurement has on public policy.

These things have to do with long-run trends and not the short-term issues that concern the Fed, Jorgenson said. In setting interest rates, he said, “the Fed focuses on indicators of inflation - commodity prices, labor costs - and we know those are going down.”

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