Inside the US Federal Reserve headquarters, a small team is testing a forecasting program that does the work of hundreds of economists. Never before has the Fed been able to crunch such a large mountain of data in real time - as many as 150 indicators - to divine where the economy is headed.
Fed chairman Ben Bernanke is pushing the factor model program - so named because it reduces everything from home sales to mining capacity into a few weighted averages for making predictions.
The Fed could use the help: its gross domestic product (GDP) forecasts, which influence its interest rate decisions, have missed the mark by an average of 1 percentage point since 2000.
"It's a powerful tool that can improve the Fed's forecasts," says Richard Clarida, a global strategic adviser at Pacific Investment Management and Columbia University economist who developed a factor model as an assistant treasury secretary in 2001.
"Forecasting, especially in real time, is a challenge and these programs are not swayed by the emotions or the conventional wisdom of the moment."
Bernanke called the models "especially promising" in a speech in 2004. He should know. In 2000, as an economist at Princeton University, Bernanke created one that examined 78 economic indicators.
He found that its short-term inflation and unemployment predictions were about as accurate as those produced by roughly 200 economists at the Fed, according to his published paper.
"That was widely regarded as a successful piece of empirical work," says Princeton economist Mark Watson, a pioneer in the field.
Bernanke also found that computers have their limits. As part of his research at Princeton, he ran a program to see what would have happened if a computer had set monetary policy from 1987 to 1998.
Forecasts from Bernanke's factor model were fed into the program, which adjusted rates based on certain rules. The result: inflation and unemployment fluctuated by larger amounts than in real life - proof that Fed officials are better than software at making calls on interest rates.
"We find this evidence for human superiority comforting," Bernanke wrote.
Columbia professor Edmund Phelps, the winner of the 2006 Nobel prize in economic sciences, agrees.
"There's going to be a huge element of uncertainty left that is not captured by the computer models," he says. "Now is a time when there happens to be an unusual amount of uncertainty."
In February, when Bernanke became the Fed chairman, the US economy was speeding ahead, expanding at a 5.6 percent annual pace. Inflation was holding steady.
He gained credibility by halting the two-year run of interest rate hikes in August as growth started to slow. Now he faces a more daunting set of facts. A plummeting housing market has raised the spectre of a recession, while inflation has nudged up.
Economists aren't providing much clarity. Their predictions for next year are sharply divided compared with their earlier calls for this year.
JPMorgan Chase argues that inflation will spur benchmark rate increases up to 6 percent. Goldman Sachs Group, taking the opposite position, sees a distinct possibility of a recession and rate cuts to 4 percent. According to the median forecast of economists in a Bloomberg survey in October and November, officials will lower rates by 0.5 percentage points to 4.75 percent next year.
The Fed is betting against a recession even after the economy expanded at an estimated pace of 1.6 percent in the third quarter. The central bank has held its rate at 5.25 percent since June, hoping that growth is slowing just enough to bring inflation down to about 2 percent or lower.
The drop in crude oil prices from July's peak of $78.40 a barrel and higher stock prices may provide a cushion for the economy, says former Fed governor Laurence Meyer, now the vice-chairman of Macroeconomic Advisers.
A barrel of Brent crude was worth $60.20 in London yesterday afternoon.
"The worst may be behind us," says New York-based Neal Soss, the chief economist at Credit Suisse Group. "Consumer outlays have been very strong."
Housing is a dark cloud in other economists' calculations. Goldman Sachs says a recession is increasingly likely because this housing slump is worse than the last two, in 1995 and from 1998 to 2000.
New single-family home sales fell 23 percent in the third quarter, and the housing market has yet to hit the bottom, says David Rosenberg, the chief North America economist at Merrill Lynch. "The chance of a recession is a coin flip right now."
Factor models, which run on a basic desktop computer, may help officials with those twists and turns in GDP, inflation and employment.
In a way, the models emulate how Bernanke's predecessor, Alan Greenspan, discerned economic trends from reams of data, says Princeton's Watson. "Greenspan was someone who had great intuition and understanding about the economy," he says.
The central bank won't say when its factor model will be used to help set policy. For now, Bernanke will have to rely on his old tool kit to try to avert runaway inflation or recession, as the case may be. - Bloomberg