Humble Jay gets it right

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An appropriately humble Fed

Jay Powell’s dislike of the summary of economic projections becomes clearer with each Fed press conference. The SEP reports, at every other Fed meeting, the estimates of the 19 members of the Fed’s Open Market Committee for growth, employment, inflation and interest rates, over the remainder of the current year and for the three years to come. It is not a basis for policy; it’s just a survey. The members’ degree of confidence in their estimates is not recorded, but it is surely very low. Its quantitative crispness, as personified by the infamous “dot plot” of rate policy expectations, is therefore an illusion. And the poor chair has to answer question after question about it. “We’ll watch the data,” he says, with perceptibly rising ennui.

Yet the SEP tells us things, whether the chair likes it or not. When it changes a lot, it shows that events have forced a group of influential people, whose job it is to think hard about the economy, to change their minds.

And on a day the Fed opted not to change rates at all, the SEP changed a lot, and in interesting ways. Here is the summary table:

Start with the economic view. Since June, growth expectations have risen notably for this year and next; expectations for unemployment have fallen notably; and expectations for inflation are all but unchanged. Six months ago, this combination would have seemed close to insane. Steady growth, extremely low unemployment, and inflation half a per cent from target? You wish, our past selves would have howled. And yet here we are. The economy, or at least big parts of it, have re-accelerated, as exemplified by the pick-up in consumer spending this summer. At the same time, core inflation has continued to trend down, even if slowly, and unemployment has risen marginally at most. Powell has long said the path to a soft landing is narrow, but it sure looks like we are walking it.

This makes the policy bit of the SEP all the more striking (that’s the bottom two rows of the table above). The committee’s aggregate expectation is for the policy rate to be 5.1 per cent at the end of next year, less than two quarter-point cuts below the current level. The market is not ready for this: futures imply a 4.7 per cent expectation in December 2024; a week ago, the expectation was 4.4 per cent. Absorbing these numbers, and Powell’s tone at yesterday’s press conference, stocks drifted down and short-term Treasury yields rose. Several reporters gave voice to the market’s agita, asking Powell if he wasn’t worried that, with inflation falling, holding nominal rates higher for longer didn’t risk an increase in real rates that would harm the economy unnecessarily. 

A fair question, but we should all bear in mind the critical lesson of the past three years: we don’t understand very much about inflation. Those who looked prescient in predicting how high inflation would rise in 2021 and 2022 — mostly economists focused on excess demand — almost universally failed to predict the rapid decline in inflation, accompanied by economic strength, that we have seen in the past 12 months. Economists whose theoretical apparatus explains the last year nicely — mostly those focused on the coronavirus pandemic supply shock — look wise now, but were almost universally wrong about how bad inflation would get in the first place. An observer who is not a partisan of either camp could be forgiven for concluding that we don’t know what is going to happen next.

A similarly careful view of how higher rates affect the economy makes sense, too. The fast rise in the policy rates seems to have affected different sectors of the economy very unevenly this time around. It has crippled commercial real estate, frozen (but not cracked) the housing market, and thrown banks for a loop. But big swaths of the economy, starting with the consumer, seem not to have noticed, even in the face of poor sentiment. That’s why we don’t even know if we are at the very beginning of an economic cycle or the very end.

Today’s economic vim may not last. Powell nodded yesterday to a litany of coming headwinds: the autoworker strike, $90 oil, resumed student loan payments, a potential government shutdown, new highs in long yields. But equally, the US consumer has powered through worse, and real wages are on the rise again. What will the net effect be? A proper growth deterioration is plausible, but so is the shortlived fourth-quarter GDP “pothole” that Goldman Sachs expects.

Given the indeterminacy, the committee is right to plan — provisionally — to keep rates higher for longer. The risk of causing a recession and the risk of allowing inflation to recur are both live, but for now punchy growth makes the latter outcome look more dangerous. But if the data changes, the Fed can, too. (Armstrong & Wu)

One good read

No one does media intrigue like Michael Wolff.