The U.S. Federal Reserve is talking up rate-hike expectations even when inflation and threats to inflation are slowing markedly. Investors should recognize that the Fed has a poor forecasting record and officials are likely to relent on their hawkish rhetoric as inflation subsides.
In 2013, then-president of the Minneapolis Fed, Naryana Kocherlakota, used a pithy metaphor to describe how constrained the Fed is when setting interest rate policy. It is much like choosing clothing. “Every morning, I have complete control over what kind of coat I wear…[b]ut of course, in making my choice of outerwear I’m merely responding to the Minnesota weather.”
The Fed can’t choose 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 during a humid Philadelphia summer or a tank top in winter. The bottom line is that the Fed is mostly responding to the economy much as I respond to the weather.
I thought this metaphor was clever and accurate, but a former professor pointed out a flaw: In reality, the Fed’s choice of clothing canend up affecting the weather. If it chooses the wrong clothing for a long time, such as rates too low for too long, it distorts economic and investment decisions, possibly with bad outcomes like say, an unsustainable housing boom. Such is the nature of metaphors: they’re never perfect.
I think of the Fed as a “tillerman,” but not the kind using the tiller on a boat to determine the boat’s direction. I mean the tiller driver of long-ladder fire trucks. That’s the person sitting in the rear steering only the back wheels, merely responding to the lead driver. The economy is up front, deciding the direction. The Fed can only react to the direction of the truck and do its best not to cause a crash.
The trouble is the Fed’s task as tillerman is near-impossible. After publishing a quarterly forecast of their expected path for the federal funds rate for 11 years, the median forecaster has only accurately predicted the committee’s actions five of those 11 times, on a calendar year basis.
Economists and investors are well aware of how often the Fed indicates they expect to do one thing, only to reverse course shortly thereafter. This happened most recently in 2019. Central bankers were confident the tightest labor market in four decades would generate high wages and high inflation, and early that year were insistent on continuing a rate-hike cycle that had started three years earlier.
But high wages and high inflation never materialized, and by the end of 2019 the Fed had cut rates by 0.75%. More recently, the inflation of 2022 caught the central bank completely by surprise. None of this is to denigrate the Fed. It’s just a near-impossible job, and there are three reasons why.
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 all the same challenges with interpretation. Are retail sales down because of high prices? Consumer weakness? Seasonal adjustment? Furthermore, macroeconomic data gets heavily revised long after it is first published. If that isn’t enough, the economy is in a constant state of change, affecting the relationships between labor, wages, output and inflation. The Fed struggles with all of the same questions about the economy as the rest of us.
2. The Fed can’t see which direction the lead driver is going to turn (forecasting inflation)
The Fed is terrible at forecasting inflation. Its track record is no better or worse than private-sector market forecasters. After Dan Tarullo retired from more than eight years as the Fed vice-chair, he told the world that the Fed “do[es] not, at present, have a theory of inflation dynamics that works sufficiently well” to do its job — a rather devastating indictment. Worse, Tarullo said economists in the Fed may rely too heavily on models that don’t work very well, and keep in mind that was before COVID disrupted all of the forecasting tools.
3. The rear steering wheel (the Fed’s set of tools) doesn’t work very well
Even if it could forecast inflation, the Fed doesn’t have a very good idea of how its tools are going to affect the outcome. There are myriad transmission channels through which monetary policy affects the economy and inflation. The Fed does not have an effective, real-time assessment on how any of these channels are operating at any given time.
“ The Fed’s projected policy rate is as subject to revision as anything else. ”
There’s a mantra in investing: “Don’t Fight the Fed.” The implication is to align one’s investment strategy with the Fed’s policy and their project policies. In the immediate future it’s fairly clear the Fed is likely to hike by 25 basis points at its next meeting on July 26. At the most recent press conference, Chairman Jerome Powell placed heavy emphasis on the personal consumptions expenditures (PCE) index of inflation, in particular the “core PCE,” which removes the volatile food and energy categories. Powell intimated an “every-other-meeting” cadence for hikes, which would put the next likely hike on November 1 — ample time for core PCE to slow as we expect.
Given these challenges, investors are better off focusing on the lead driver — the economy. Too much ink is spilled describing a Fed that’s trying to convince markets it will “stick to its guns” and not lower rates this year, for example, but markets aren’t listening. The truth is the Fed and markets simply have a different forecast, and the Fed’s projected policy rate is as subject to revision as anything else.
Look at the front of the truck. The economy is slowing, quickly. Consumer spending, producer prices, job growth, wages, you name it: they’re all slowing. The Personal Consumption Expenditures (PCE) price index was up just 3.9% in May, down from 7% less than a year ago, and the dreaded core-services-ex-shelter has slowed to a pedestrian 2.7% in the past three months.
Even if Personal Consumption Expenditures (PCE) inflation only falls to the FOMC median forecast of 3.2% by the end of 2023, a Fed funds rate of 5% is excessive for an economy that has grown just 1.6% over the past four quarters. That growth is down from 5.7% at the end of 2021, the strong growth that caused the inflation in the first place. Over the long-term, Treasury-Inflation Protected Securities (TIPS) breakevens are extremely low, probably too low. Surveys of expected inflation are low as well. Once the Fed realizes which way the economy is turning, it will turn too.
Luke Tilley is chief economist and head of Asset Allocation and Quantitative Services for Wilmington Trust Investment Advisors, the investment advisory arm of Wilmington Trust and M&T Bank. Tilley is a former officer and economic advisor with the Federal Reserve Bank of Philadelphia.