A jittery Fed meets serene markets

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Happy New Year to all central bank watchers and thanks again to Claire Jones for writing an excellent dispatch last week. The new year promises to be pivotal, with interest rate cuts amid domestic and geopolitical upheaval. I would love to know what you think is in store. Email me: chris.giles@ft.com

Markets vs the Fed

Everyone knows that financial markets are far ahead of the Federal Reserve in expecting interest rate cuts. In December, officials said that three quarter-point rate cuts were likely to be needed in 2024, but traders are betting on five or six, starting in March.

Underpinning this difference is a deeper divide over the economic outlook. The Vix index, which measures Wall Street’s “fear gauge” — has been trading at levels well below its average. On the same standardised score, US economic policy uncertainty, measured by the frequency of expressions of doubt about economics and policy in news articles alongside economic forecast variability and temporary tax code provisions, is also well below average. (These are shown in the chart below, which you can click on to get a more interactive version online.)

In comparison with markets, journalists and economists, the Fed’s own policymakers are still much more uncertain about inflation than normal. In the December summary of economic projections, 15 Federal Open Market Committee members said their level of uncertainty over inflation forecasts was higher than the average over the past 20 years while four said it was broadly similar, giving an uncertainty score close to the maximum possible.

Since Fed governors think the inflation outlook is highly uncertain, it is far from surprising that there is official pushback against the market belief that the first of a series of rate cuts will start in mid-March, just two months away.

But the uncertainty measures are more interesting and complex than simply showing that Fed governors remain uncertain. In the above chart, I standardised everything so I could draw it with the same y axis and no cheating. Below, I have drawn the raw Fed uncertainty scores over headline inflation, core inflation, GDP growth and the unemployment rate.

From this there are two things to note. First, officials are hugely reluctant ever to say that they think there is lower uncertainty than over the past 20 years. The index is -1 when all governors say there is lower uncertainty and 1 when all governors say there is higher uncertainty. But this measure has been negative for core PCE inflation alone and only once in September 2016. Since the past 20 years includes the global financial crisis, the Covid-19 pandemic and Russia’s invasion of Ukraine, Fed governors are either weirdly certain that the future will be horribly bumpy or unwilling to engage properly with the question.

Second, the uncertainty scores correlate strongly except in 2012, even though inflation forecasts were surely more certain than real economic variables between 2007 and 2020 and have been less certain ever since.

FOMC members are also asked to rate whether risks around their forecasts are weighted to the upside or downside. The results here are interesting for the difference between the inflation variables and the real variables. On inflation, the risks were skewed towards the downside in general in the 2010s and upside thereafter. Governors almost always think their GDP growth risks are skewed towards the downside and unemployment towards the upside. Given there was a fear of deflation in the 2010s, the upshot is that the FOMC almost always says the risks are weighted towards a bad outcome.

While most drivers think they are better than average, most FOMC members think their forecasting record is deteriorating and outcomes will be worse. They really are miseries.

Apart from noting the peculiarities of the Fed’s forecast uncertainty scores, there are four things we can conclude, none of which are mutually exclusive.

1. The uncertainty scores and risk weightings are fake and simply designed to cover the backs of those producing them (“Oh, the world is so difficult to predict, don’t blame me if I’m wrong”).

2. The scores are unimportant. FOMC members pay no attention to their odd results and they have little bearing on policy.

3. The scores reflect genuine doubt, correctly held by FOMC members. Uncertainty is much higher than over the past 20 years and outcomes are more likely to be bad, so it makes sense to wait longer than markets expect before reducing interest rates. If true, this is the correct policy conclusion.

4. The scores reflect genuine doubt, incorrectly held by the FOMC. This is the recipe for a policy error by a Fed frozen by fear and uncertainty in ways others do not understand.

As far as markets are concerned, they are betting that the scores are fake or unimportant. Next week, I will examine the uncertainty and biases evident in other central banks’ forecasts.

What I’ve been reading and watching

• In my column last week, I argued that central banks would be able to declare victory over inflation this year and should cut rates early but slowly

• If you want to read the classic argument for why green mandates for central banks are likely to achieve nothing, read Tony Yates urging governments to act instead

• If you want to track the effect of Houthi rebels on the Suez Canal, let me recommend the ultra-cool portwatch website of the IMF — there has been a big drop in traffic

• Lorrie Logan, president of the Dallas Fed, fuelled investors’ hopes of a slowing in quantitative tightening in a speech at the weekend. The irony is that were investors to cheer the speech with lower bond yields, she would want higher interest rates, as she made clear in her words

• In an extremely welcome development, the ECB has published a first set of up-to-date wealth inequality statistics, splicing together detailed but out-of-date household finance information with changes in aggregate wealth. It estimates that in the eurozone, median wealth has grown more than 40 per cent since 2015 at the same time as wealth inequality has decreased. A good result for Europe

A chart that matters

What is happening with eurozone inflation? The figures for December were out last week and showed a rise in the headline rate from 2.4 per cent in November to 2.9 per cent in December. The rise resulted entirely from energy subsidies which lowered prices the previous December.

A better way to look at inflation trends is to examine the annualised price trends for headline, core and services inflation over every period for the past two years. As you can see, high inflation rates are increasingly moving into the past. For readers of this newsletter on email, it is clearest if you click on the chart and go to the interactive online version.