Expectations play a significant role in explaining human behavior. Expect a slight chance of rain and you may not take an umbrella. Expect that the hurricane gaining strength off the coast is going to hit your town and you are likely to take precautions. Expectations also are important in explaining the current economic situation.
The latest data show a marked decline in July home sales. One reason for this falloff is that sales were artificially high in the spring. At that time, the government was well into its tax credit for homebuyers to increase home sales. Those who thought they might buy a home later during the year accelerated their buying decision before the deadline. Expectations were changed by the program.
With the housing market still mired with an excess inventory, many now are postponing their purchase on the expectation that prices may fall even further. Others are delaying because they expect that a continued slump will lead to another tax credit program. Given such uncertain expectations, it makes sense to defer purchases. Unfortunately, this behavior prolongs the correction in housing.
Expectations also affect decisions by businesses. Many (wrongly) believe that the passage of health care and financial regulation bills automatically instituted new operating procedures. Only now are the rules being established — answering the question of how will the legislation be implemented. Until those are completed, businesses owners remain uncertain of how the new policies will affect them. And this uncertainty has stalled hiring decisions.
Uncertain expectations of future tax liabilities also impact current behavior. Will the Bush tax cuts be extended or not? How will they be altered, if at all? For businesses and individuals alike, uncertainty about future taxes is leading to delays in hiring and spending decisions.
Many expect mixed signals about future tax and spending policies out of Congress and the White House. Unfortunately, the Federal Reserve has now gotten into the mix.
Markets anticipate, perhaps unfairly, that the Fed can deftly steer the economy between the Scylla of high inflation and the Charybdis of high unemployment. Sometimes the Fed takes a firm stand against one of these economic evils: In the late 1970s, it announced that because inflation was too high, it would change policy to reduce it and that high rates of unemployment would be the cost. This transformation in policy goals generated a substantial recession, but it greatly altered expectations about inflation. The low-inflation path it created helped sustain economic growth over the next two decades.
Now the Fed faces a dilemma. Monetary policy has been extremely expansionary. Yet the recovery is tepid and some raise the fear of future inflation. Conflicting economic outlooks are not new at the Fed. What is different is the public airing of such policy disputes amongst members of its Federal Open Market Committee (FOMC). As revealed by the minutes of its last meeting and in public speeches by Fed officials, there is more than the usual disagreement among Fed officials about the direction that policy should take.
FOMC members traditionally argue behind closed doors over alternative policies. But allowing the public to witness this internecine squabble during a time of economic distress erodes confidence in future policy decisions. It is adversely affecting market expectations.
Fair or not, markets expect monetary policy makers to have a better grasp on the situation than they appear to. Market participants anxiously anticipate such clarity of direction from Chairman Bernanke’s speech that he is delivering today at a Fed conference in Jackson Hole, Wyo. (Text of Bernanke's speech )
Uneven fiscal and monetary policy exacerbates uncertainty that, in turn, breeds inaction. Businesses and individuals are parked on the sidelines waiting for the fog over fiscal and monetary policy to dissipate. Only until that happens will banks once again make loans, businesses increase their payrolls, and individuals spend, even for homes.
R.W. Hafer is the distinguished research professor and chair in the Department of Economics and Finance at Southern Illinois University Edwardsville and a research fellow at the Show-Me Institute. This article originally appeared in the St. Louis Beacon.