David R. Kotok, September 22, 2024
(The following was first published on The Kotok Report website and via LISTSERV. For details, visit https://kotokreport.com/.)
Today let’s consider why the Fed should always operate “behind the curve” (where there is data to rely on).
It is important to note that the yield curve is not inverted anymore. I’m ignoring the very short-term interest rates, which are now projected to fall two full percentage points over the Fed’s “dot plot” projection period. I’m looking at the range from 2 years to 30 years in the yield on US Treasury obligations, whether notes or bonds.
My recent Kotok Report commentary about the U7 is also relevant (“Claudia, Danny, Michael, The U7 & Me,” https://kotokreport.com/claudia-danny-michael-the-u7-me/). I thought of it when Chair Powell mentioned the inflation impacts on certain more vulnerable folks within the working or want-to-be-working cohorts. Those are the U7 people.
Powell made it as clear as he could that the Fed sees its role independently of the political calendar. He reminded us that this is his fourth election while at the Fed. He affirmed the Fed’s dual mandate of (1) keeping inflation low while (2) the unemployment rate is also kept low. Many commentators try to dissect that mandate and constantly chide the Fed for being “behind the curve” about one factor or the other.
IMO, the Fed must be behind the curve all the time. And I think that’s a good thing. Here’s why.
The members of the Federal Open Market Committee (FOMC) have a plethora of resources and much skill and experience among the hundreds of practitioners and researchers in economics who work for them. I know some of them personally and have had the pleasure and honor of working with them during my 50-plus years in the financial markets arena. Allegations and assertions that there is some type of cabal or hidden plan or political agenda in the workings of the Fed are wrong. Ridicule of the Fed is just plain misdirected.
Every reasonable economist knows that any model for forecasting the future is wrong the minute you make the forecast. All models are inaccurate. That is an absolute. We use them to make guesses, and we use mathematical techniques to try to derive probabilities or likelihoods of outcomes. But each of us knows that the modeling we are doing is not perfect. The Fed knows that, too.
So, should the Fed make all its decisions based on inaccurate models? Some might say yes. But I would say, please don’t.
The inherent inaccuracy means that the process has a second part, which is gathering a mass of information, distilling it to produce a workable description of where things stand, and then trying to apply the information to an economy that is the largest in the world and the most open and liquid and legally defended in the world. Imagine doing that every eight weeks, and you have just contemplated what the process is within the Federal Reserve. Is it daunting? Damn right it is. Is it critically important? Damn right it is.
So, now we get to why there are different views articulated around the room at the FOMC. And we get to the process where a dissenting vote is permitted. The idea here is that not all parties fully agree on everything macroeconomic. Dissent by an FOMC governor is rare, but it happens. Dissents by presidents are infrequent, but they happen. If you want to dig deep, look at the votes in the 12 regional Fed banks when the FOMC is asking whether the Fed should change the discount rate. I know that is technical, and it doesn’t get attention in the media, but it is a way for a regional bank president to send a message of her or his intentions or opinions about future Fed policy. Note that this messaging takes place without the need for an official dissenting vote.
Were I voting on the recent policy rate change, I think I would have been in the quarter-point camp. But I say that sitting outside the FOMC meeting room, without the benefit of the information shared at the meeting. Note that Governor Bowman did favor a lowering of interest rates. It was the amount and not the direction that became the subject of a dissenting vote.
So here we are. The Fed is on a downward interest rate trajectory. The economy is now under a microscope in terms of whether we’ll get a soft landing or something harder. I will look at inflation data and for any stress in payments. Credit spreads are critical, and they are presently tight and saying no recession. And when the employment report comes out next month, I want to see what the U7 does and in what direction it’s shifting and compare it with the U3. Maybe it will tell us that the Fed is not behind the curve. Who ever said economics was boring?