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Time for the Fed to join the 21st century

Tibco CEO Vivek Ranadivé says it's time to replace the antiquated Federal Reserve model with a computer program.

Some of the most successful companies in the world, such as Wal-Mart and Federal Express, derive significant benefits from the information advantage they receive each and every day through the visibility of real-time data.

These benefits allow them to adjust quickly to inevitable changes in their businesses. Unfortunately, while businesses and consumers are real time, the government continues to operate in batch mode.

Nowhere is this more true than at the Federal Reserve, whose actions have a greater impact on people's lives than any other single body of governance. Briefly put, the Fed's job is to ensure a suitable temperature in the economy so that and unemployment migrate to appropriate levels. If you applied the Federal Reserve approach to ensuring a suitable temperature in your home, you would turn the heater on and off every three months, overheating or under-heating your house.

That's precisely what seems to happen to the economy--a not too hot or too cold "Goldilocks economy" is what, in theory, the Federal Reserve aims toward. Ironically, four of the past five tightening campaigns (1973, 1980, 1990, 1994, 2001) initiated by the Federal Reserve resulted in recession.

Only in 1994 did the Federal Reserve avoid recession and achieve the desired goal of a soft landing. Not exactly a record I would want to risk our economic future on, and yet each month we anxiously await another Fed meeting on pins and needles, dissecting whether or not the Fed, using old, stodgy data, will raise rates or hold firm.

In my mind there are three simple principles the Fed needs to adopt to regain integrity.

First, it should expand its sources of data.

Whether it be information on consumer spending, productivity or manufacturing activity, backward-looking data is only so helpful, especially given the complexity of today's global economy. Wouldn't it make sense for the government to really get online and connected like the corporations it tracks and supports?

If Wal-Mart can tell you exactly how much of which products it sells as it's selling them, you would think the government could use more real-time feeds into this data. And Wal-Mart isn't unique in these abilities; FedEx can provide real-time results on shipping operations; General Motors on car sales; ADP on employment data; Intel on chip manufacturing. The list of real-time companies goes on and on. Government entities, however, seem slow to jump on this bandwagon.

If the Federal Reserve were to combine the use of historical data with real-time feeds from a number of additional data sources, I believe there would be fewer policy blunders and a higher probability of achieving the Fed's statutory goals of maximum employment and stable prices.

Second, instead of the Federal Reserve meeting eight times per year to decide whether or not the federal funds rate needs to be adjusted, the rate should continuously adjust in real time through a closed loop mechanism.

The third and final principle would be to implement tiny interest rate adjustments.

Instead of the typical 25 basis point move, the model should move in increments as small as 1/100th of a point. The new Fed chairman wants to provide more clarity--what better way than to let people see the rate and potential rate change every day based on incoming data? This computer-based model would officially welcome the Federal Reserve to the real-time information age.

But, with all the positives of a computer-based model, the system still has to be flexible enough to allow for unpredictable changes in aggregate demand or supply-side shocks. Examples of such shocks on the demand side are shifts in consumer and business confidence and changes in lending of commercial banks and other creditors.

On the supply side, there are natural disasters, unforeseen events like September 11, disruptions in the oil market that reduce supply, and even changes in productivity growth. The Federal Reserve needs to have the ability to manually override the system, similar to how it raises or cuts rates between scheduled meetings when necessary. This flexibility is critical due to the potential for unpredictable events that could negatively impact the economy.

I believe our economy and the effectiveness of the Federal Reserve would be better served if the Fed adjusted to life in the 21st century. If not, we are likely to face more policy blunders with far-reaching consequences.