The US Federal Reserve is expecting interest rate hikes, even if inflation and the risk of inflation are falling significantly. Investors should be aware that the Fed’s forecasts are poor and officials are likely to ease off their hawkish rhetoric as inflation eases.
In 2013, then-Minneapolis Fed President Naryana Kocherlakota used a succinct metaphor to describe how limited the Fed is in setting interest rate policy. It’s like choosing clothes. “Each morning I’m in total control of what type of coat I wear…[b]But of course I only react to the weather in Minnesota when I choose my outerwear.”
The Fed can’t decide on extremely high interest rates in a weak economy or really low interest rates in a hot economy, any more than I can wear a winter parka in a wet Philadelphia summer or a tank top in the winter. The bottom line is that, for the most part, the Fed is reacting to the economy the way I react to the weather.
I thought that metaphor was clever and accurate, but a former professor pointed out a mistake: In reality, the Fed’s clothing choices can affect the weather. If she wears the wrong clothes over a long period of time, such as interest rates being too low for too long, she distorts economic and investment decisions, with potentially bad consequences such as an unsustainable real estate boom. That’s the nature of metaphors: they’re never perfect.
To me, the Fed is a “tiller man,” but not the type to use a boat’s tiller to dictate the boat’s direction. I mean the tiller driver of fire engines with long ladders. This is the person who sits in the back and controls only the rear wheels and only reacts to the main driver. The economy is ahead and determines the direction. The Fed can only react to the truck’s direction and do its best not to cause an accident.
The problem is that the Fed’s job as helmsman is nearly impossible. After releasing an 11-year quarterly forecast of likely policy rates, the median forecaster has accurately predicted the committee’s actions only five of those 11 times on a calendar year basis.
Economists and investors are aware of how often the Fed says it expects something, only to change course shortly thereafter. This last happened in 2019. Confident that the tightest labor market in four decades would lead to high wages and high inflation, central bankers insisted earlier in the year to continue the cycle of interest rate hikes that had started three years earlier.
But high wages and high inflation did not materialize, and by the end of 2019 the Fed had cut interest rates by 0.75%. Most recently, inflation caught the central bank by surprise in 2022. None of this is meant to denigrate the Fed. It’s just a near-impossible task, and there are three reasons for that.
1. The Fed can’t see the front of the truck (the current economy) very well
The Fed doesn’t have a good idea of the current state of the economy. It has roughly the same data as the public and faces the same challenges in interpreting it. Are retail sales falling due to high prices? consumer weakness? seasonal adjustment? In addition, macroeconomic data are subject to major revisions long after they are first released. But that’s not all: the economy is in constant flux, affecting the relationships between work, wages, production and inflation. The Fed grapples with the same questions about the economy as all of us.
2. The Fed cannot see in which direction the main driver will develop (inflation forecast).
The Fed is bad at predicting inflation. His track record is no better or worse than that of private market forecasters. After Dan Tarullo retired after more than eight years as Fed Vice Chairman, he told the world that the Fed “does this.”[es] “We currently do not have a theory of inflation dynamics that works well enough” to do the job – a rather damning charge. Worse, Tarullo said Fed economists could over-rely on models that don’t work very well, and consider that this was before COVID messed up all forecasting tools.
3. The rear steering wheel (the Fed’s tool kit) doesn’t work very well
Even if it could predict inflation, the Fed has no precise idea of how its tools will affect earnings. There are countless transmission channels through which monetary policy affects the economy and inflation. The Fed does not have an effective, real-time assessment of how any of these channels are performing at any given time.
There is a mantra to investing: “Don’t fight the Fed.” The implication is to align your investment strategy with the Fed’s policy and project guidelines. Looking ahead, it’s pretty clear that the Fed is likely to hike rates by 25 basis points at its next meeting on July 26th. At the recent press conference, Chairman Jerome Powell put a lot of emphasis on the personal consumption expenditure (PCE) inflation index. specifically the “core PCE” that removes the volatile food and energy categories. Powell hinted that rate hikes should come every two sessions, making the next likely hike on Nov. 1 – plenty of time for core PCE to slow as expected.
Faced with these challenges, investors are better off focusing on the main driver – the economy. Too much is written to describe a Fed trying to convince markets that it is “staying the course” and not cutting rates this year, for example, but markets are not listening. The truth is that the Fed and the markets simply have a different forecast and the Fed’s forecast for interest rates, like everything else, is subject to revision.
Look at the front of the truck. The economy is slowing down quickly. Consumer spending, producer prices, job growth, wages and more: they are all slowing down. The personal consumption expenditure (PCE) price index rose just 3.9% in May, down from 7% a year ago, and the feared price index for core non-shelter services has hovered at an average for the past three months Value decreased by 2.7%.
Even if personal consumption expenditure (PCE) inflation only falls to the FOMC median forecast of 3.2% by the end of 2023, a fed funds rate of 5% is overkill for an economy that has only increased by 1.6% over the past four quarters % has grown. That growth is below the 5.7% seen at the end of 2021, the strong growth that caused inflation in the first place. Over the long term, Treasury-Inflation Protected Securities (TIPS) breakevens are extremely low, probably too low. Expected inflation polls are also low. Once the Fed sees where the economy is headed, it will turn around.
Luke Tilley is Chief Economist and Head of Asset Allocation and Quantitative Services at Wilmington Trust Investment Advisors, the investment advisory arm of Wilmington Trust and M&T Bank. Tilley is a former Federal Reserve Bank of Philadelphia official and economic adviser.
More: Why the Fed’s inflation manipulation leaves the economy vulnerable to stagflation
Also read: “There is nothing in the data to point to a price drop”: The US housing market shows remarkable resilience.
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