Bad forecasts are NOT an excuse
Expect to see lots of excuses coming out of the Fed along the lines of, “Almost no one expected inflation to get this bad”. That’s true, but it’s no excuse. A few people did forecast very high inflation, but it is true that most people (including me) did not expect inflation to get this high. But bad forecasting is not the primary problem.
The current inflation problem, or at least the demand-side inflation portion of the problem, comes from the Fed’s decision to make FAIT asymmetric, making up for inflation shortfalls but not overshoots. That’s the problem, not the fact that the Fed misjudged the situation. Under an effective policy regime (such as NGDP level targeting or symmetrical FAIT) Fed misjudgments are far less costly than under the current regime. When demand is becoming too strong, markets would quickly correct policy mistakes by moving longer-term interest rates up to a level that would restrain spending, in anticipation of future Fed rate changes. That did not happen in 2021.
Here’s another misconception. People say that 5-year TIPS spreads have not changed much over the past 6 months, therefore the inflation situation is not getting worse. That overlooks the fact that actual inflation over the past 6 months has been extremely high. Thus the market forecast of where the price level will be at the end of 2026 is significantly higher than it was just 6 months ago. The inflation situation is clearly getting worse. And five years from now, many of the current supply bottlenecks will likely be resolved.
Another argument is that inflation doesn’t matter, it’s NGDP growth that matters for monetary policy. I agree, but NGDP growth has also been far too high.
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14. June 2022 at 15:55
“Mr. Hanke, predicted in these pages (WSJ) last July that year-end inflation for 2021 would “be at least 6% and possibly as high as 9%.”
https://www.wsj.com/articles/powell-printing-money-supply-m2-raises-prices-level-inflation-demand-prediction-wage-stagnation-stagflation-federal-reserve-monetary-policy-11645630424
https://www.wsj.com/articles/money-supply-inflation-friedman-biden-federal-reserve-11626816746?mod=article_inline
“Powell cited 1965, 1984 and 1994 as examples where the FED corrected the economy without a recession.” Interest rates are not the primary determinate of GDP.
link: Daniel L. Thornton, Vice President and Economic Adviser: Research Division, Federal Reserve Bank of St. Louis, Working Paper Series “Monetary Policy: Why Money Matters and Interest Rates Don’t” bit.ly/1OJ9jhU
Everyone should write their District Reserve President and ask them about N-gDp targeting.
14. June 2022 at 18:04
At least now we won’t have to listen to people talk about how “demographics” and “technology” mean that its impossible for central banks to get inflation up to their targets and how there’s “nothing more the Fed can do”. It was a whole decade of listening to that nonsense and it felt more like a century.
Trying to look on the bright side here.
Although maybe now we’ll hear some recycled nonsense from the 1970s about how its impossible for the Fed to get inflation lower because of oil, war, minimum wage hikes, weak productivity, ect, ect.
14. June 2022 at 18:30
Why is high NGDP bad? I get why too low is bad (unemployment) but what real effects does high NGDP have aside from inflation?
14. June 2022 at 18:41
Classical Liberal, I’ve thought the same thing.
Thrawn, Two issues:
1. High NGDP usually leads to unstable NGDP, which creates business cycles.
2. High persistent NGDP growth that is fully anticipated is less bad, but still has the so-called welfare costs of inflation, such as less capital formation.
14. June 2022 at 18:48
Interesting, do we know why high NGDP would lead to unstable NGDP? The cynical view I’ve heard is that high NGDP means strong labor, and businesses go on a capital strike to reclaim power.
14. June 2022 at 19:12
Had the Fed used my model, they would have seen the mean expected NGDP growth path exceed 4% in March of last year and seen it head to just above 5%. Would it have mattered to them? I don’t know, but all the information the Fed needed was available in the form of market forecasts.
14. June 2022 at 21:25
Thrawn, There is no such thing as capital strikes.
Michael, Again, it’s not about the forecasts, it’s about the bad policy regime they have.
15. June 2022 at 06:25
Scott – the latest thinking is that the Fed was way too loose in 2021. But if you look at the 10 year breakeven (https://fred.stlouisfed.org/series/T10YIE), the average in 2021 (until ~October) seems to be ~2.3% – which equates to a PCE of about 2, right? Is it correct to say the Fed was too loose *throughout* 2021, or just that they needed to react faster in the back half of the year when inflation expectations started spiking?
15. June 2022 at 06:53
The Fed has been ‘quantitatively tightening’ for more than 6 months
https://tsi-blog.com/2022/06/the-fed-has-been-quantitatively-tightening-for-more-than-6-months/
And if the Treasury’s General Fund Account had not increased, from 84.954 on 12/22/2021 to 723.384 on 6/8/2022 the money stock would have grown too fast (albeit it eventually is necessarily included).
The N-gDp model was growing too fast as early as the 1st qtr. of 2021:
2021-01-01 10.9
2021-04-01 13.4
2021-07-01 8.4
2021-10-01 14.5
2022-01-01 6.5
The FOMC should have tightened as early as the 2nd qtr. 2021.
But using interest rate manipulation as its monetary transmission mechanism, under an ample reserves regime, the time-frame of the FOMC’s horizon was 24 hours, rather than 24 months.
15. June 2022 at 07:25
Just another example of policy asymmetry. Never did in hear in 2008/09 – “our forecasts were wrong, we’ll eventually get back on track but it’s going to take a lot of time and we don’t want to move too suddenly.”
15. June 2022 at 08:04
Scott,
Yes, the Fed has a bad policy regime, in that it would be suboptimal even if well-defined. The fact that it’s vague makes it much worse. I get that.
That said, if they ever do NGDP level targeting, they’ll need a forecast to do that optimally. Using the S&P 500 index is the next best thing to using NGDP futures.
15. June 2022 at 08:16
sd0000, My own view is that the Fed became too loose late in 2021. But it’s hard to set a specific date, as the real problem was the Fed’s asymmetric FAIT approach, and I don’t know when markets became aware of that.
Effem, Actually, the problem in 2009 is that they did take too long to get back on track. This time they got back to trend quickly after the Covid slump, but overshot. You are correct that they are addressing the high inflation too slowly.
15. June 2022 at 09:35
It’s not rocket science. The FED’s Ph.Ds. don’t know a credit from a debit. It’s not just theoretical, there’s empirical evidence.
Lending by the banks is inflationary. Lending by the nonbanks is noninflationary, other things equal. The nonbanks are not in competition with the banks. The NBFIs are the DFIs customers. The elimination of Reg. Q ceilings was a huge mistake.
The latest Atlanta GDPnow forecast is zero percent. Raising policy rates disproportionately affects the nonbanks or the velocity of circulation (because of paying interest on reserves). It reduces R-gDp faster than inflation.
Link: REGULATION Q AND THE BEHAVIOR OF SAVINGS AND SMALL TIME DEPOSITS AT COMMERCIAL BANKS AND THE THRIFT INSTITUTIONS by Timothy Q. Cook
https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_review/1978/pdf/er640602.pdf
The “demand for money” is fickle. It fluctuates more than the money stock. But the FED discontinued the G.6 Bank Debits and Deposit Turnover Release in Sept. 1996 for spurious reasons.
In 1931 a commission was established on Member Bank Reserve Requirements. The commission completed their recommendations after a 7 year inquiry on Feb. 5, 1938. The study was entitled “Member Bank Reserve Requirements — Analysis of Committee Proposal” its 2nd proposal: “Requirements against debits to deposits”
http://bit.ly/1A9bYH1
After a 45 year hiatus, this research paper was “declassified” on March 23, 1983. By the time this paper was “declassified”, Nobel Laureate Dr. Milton Friedman had declared RRs to be a “tax” [sic].
15. June 2022 at 10:21
“asymmetric FAIT approach, and I don’t know when markets became aware of that.” – where can I read more about this?
15. June 2022 at 10:22
I think you are absolutely correct that the asymmetry of FAIT, which was not clearly explained until fall of 2021 or early 2022, is the main cause of the current inflation. They have not even put a numerical limit on how bad they will let these so-called overshoots get, or how long they will let them run, before acting. Once that purchasing power is lost, of course, it will never be regained. Until they explicitly repudiate this position, cash will remain a very risky asset, and there is a whole lot of cash out there, compared to what there was in the 1970s.
15. June 2022 at 10:22
To clarify my last comment, how did you become aware of it? What policy was changed exactly? My understanding is the Fed had been undershooting inflation for almost a decade. Did they make all that up already?
15. June 2022 at 10:47
The market did not seem to believe inflation would be as high as it is, based on TIPS spreads and other market indicators.
Does this indicate a problem with relying on market indicators when setting monetary policy?
Is it possible that the Fed followed the path it did because it relied, in part, on these indicators?
15. June 2022 at 11:03
Scott,
It’s a question of precision. When in doubt, build a chart. 10y inflation expectations dipped below 2% on August 8, 2008. By December 16 they had cut the Fed Funds rate 200bp.
10y inflation rose above 2% on January 5, 2021. Now, on June 15, 2022 they have increased rates 150bp. (I use the lower band for all calcs).
That’s a very large asymmetry. Personally, i believe it’s a structural asymmetry that needs to be accounted for in any discussion of targets or mandates.
15. June 2022 at 11:23
So, did the blog post (and comments) on this topic come before or after the current 0.75% interest rate decision? The FED seems to have gotten the message, or not? Yeah, yeah, okay, Scott will tell me again what I didn’t understand — if he is gracious and has the muse to do so.
15. June 2022 at 15:03
Thrawn, Powell clearly repudiated the policy in early January, but I assume the markets had already suspected this by the middle of 2021.
Foosion, The markets have been ahead of the Fed. Yes, the markets didn’t anticipate the Ukraine War, but the biggest problem is that the markets did not anticipate that Fed policy would end up being this bad.
Christian, The blog post came first, and no, the Fed has not gotten the message. They are still behind the curve.
15. June 2022 at 18:49
It’s just interesting that the goal posts keep changing. First it’s forecast and prediction models, then it’s transitory, then not so transitory. Now its FAIT.
I suppose if you shoot enough bullets at the target, you are bound to hit it once.
But Good news: GOP Latina, wife of a border agent, destroys the marxist left in a very left Texas town. First time the district has been carried by GOP since the 1880’s. A return to the old right? Maybe a return to pre-fed, pre-roosevelt, pre-progressive socialism? We can only hope.
https://www.zerohedge.com/political/gop-flips-84-hispanic-texas-district-first-mexican-born-woman-elected-congress
Let’s see how long the marxist wing of the party lasts after they lose the house for a decade.
15. June 2022 at 19:55
What is the point of creating a model, if the model cannot predict anything of value?
When you say the problem isn’t “forecasting” — well, okay. But the whole point of a model is to forecast sucessfully. Clearly, if it doesn’t, then it’s useless, and the people propogating it are charlatans.
In Physics, the numbers add up. They work. It’s beautiful. It’s science. It’s real, tangible, verifiable — it’s awesome.
Econ has certain fundamental truths, axioms, such as supply and demand, and I’d go as far as to say subjective theory of value, conspicious consumption, elasticity, etc, etc. All good stuff and worthy of reading about.
But monetary theory is a psuedoscience. Sorry. You guys are so far down the rabbit hole that you are totally incapable of finding your way out.
15. June 2022 at 21:33
What prevents the Fed from meeting and voting more frequently like Scott has suggested? Are they afraid that swifter and more frequent actions on the money supply would harm their credibility as a deliberative body? When Pearl Harbor was bombed Roosevelt and Congress didn’t spend 6 months debating foreign policy changes.
The Hypermind market is still skewed by participants who don’t understand NGDP. I think we can apply last year’s error band of 3%–which points to 2022 ending up at 9ish%–which implies that Fed policy is about 9 months behind on bending the growth curve. Don’t ask me for my methodology on that assessment because it’s Trailer Park Boys dead reckoning.
16. June 2022 at 00:26
‘Someone’ is optimistic?
“YouTube is loaded with stock market bears. – YouTube . . .
3:12 drop in reserve assets on the books of
3:14 the banks
3:15 and that’s allow the banks to create
3:19 more loans not less loans . . . “ ?
https://www.youtube.com/watch?v=ne6rqCfYEDg&t=4s
[the] drop in reserve assets on the books of the banks and that’s allow the banks to create more loans not less loans?
16. June 2022 at 03:09
Scott, it seems like momentum is building in the UK to end IOER.
How would you analyse the effects of this proposal?
https://www.ft.com/content/24f51ce8-1a61-4e03-95d3-e87f2c9d938b
16. June 2022 at 07:11
re: “But monetary theory is a psuedoscience”
The FED has never been very cooperative in supplying the chain linked data that’s required for models. Sometimes there’s only seasonally adjusted data, sometimes their definitions are wrong, etc. The FED’s stats need audited.
16. June 2022 at 07:47
@Sarah:
The incontrovertible reason why economics is called the dismal science is the Keynesian macro-economic persuasion that maintains a commercial bank is a financial intermediary serving as a conduit between savers and borrowers. Never are the commercial banks intermediaries in the savings-investment process. The utilization of bank credit to finance real investment or government deficits does not constitute a utilization of savings since bank financing is accomplished by the creation of new money.
Commercial banks acquire earning assets through the creation of new money. When commercial banks make loans to, or buy securities from, the nonbank public -new money, demand deposits, are created — somewhere in the commercial banking system. Ergo, all bank-held savings are lost to both consumption and investment.
Dr. Philip Georges equations prove this.
http://www.philipji.com/riddle-of-money/
TMS definitions prove this: “Shostak notes that “claims on dollars held in savings deposits typically do not circulate in exchange,”
16. June 2022 at 08:48
Theo, I’d favor ending IOER, but this doesn’t do it and is a terrible idea:
“Under the think-tank’s proposal, each commercial bank would be required to hold a substantial amount of money at zero interest, with the BoE’s interest rate paid on only the last tier of money. This would ensure that the BoE’s interest rate still underpinned the financial system.”
16. June 2022 at 09:22
Scott, TIPS spreads are now implying inflation a bit above 2% at 10 and 30 years (5 years is a bit higher) and have been doing so consistently for some time, presumably with full knowledge of the Feds actions.
That does not seem like “the biggest problem is that the markets did not anticipate that Fed policy would end up being this bad.”
FWIW, CME FedWatch seems an excellent market estimator of what the Fed is doing. The Fed almost always acts in accordance with its high percentage probabilities.
16. June 2022 at 14:45
As I’ve been thinking about there recent Fed decision there’s a point that’s been bugging me. Why would the Fed predict future interest rate increases? Is that not basically the same as saying “we lacked the will /political cover to do the necessary acts now”.
I am basing this on one of the fundamental truths of pricing. If a price is going to be different tomorrow, the correct action today is to act like it’s already there today modulo time based adjustments.
So to acknowledge that in the space of weeks (next meeting) they expect to raise interest rates again is basically admitting that they took insufficient action. Only if their forward guidance was “we did what we think is necessary, we’ll revisit obviously, but our prediction is no future increases” would they look like they understood the basics of setting appropriate prices.
Is there something that makes the price of money different? What am I missing? This seems like an obvious thing and the Fed governors are not stupid people in general.
17. June 2022 at 08:03
foosion, The 5-year TIPS spread is around 3%, implying 2.7% PCE inflation. In any case, my point was that even in late 2021 the TIPS market was warning that policy was too expansionary.
Dan, Even in an efficient market, prices may be expected to move over time. But yes, the Fed moves too slowly.