It's All Coming Apart At the Seams As the Errors Multiply

It's All Coming Apart At the Seams As the Errors Multiply
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The unemployment rate fell within the range Economists have defined for full employment years ago. In early 2015, in fact. All the most sophisticated econometric models ever produced declared the moment had arrived, full and complete recovery at long last.

Only, they’ve spent the balance of the last four years (four!) predicting wage-driven inflation as a consequence of full employment, failing to find it, and therefore redefining the term rather than treat it as falsified dogma. It’s not as if the unemployment reversed or even stalled out. Quite the opposite; the figure declined even more, a lot more.

By the early part of last year, the BLS’s big stat claimed the economy was in practically uncharted territory. The rate had moved below 4%, quite a difference from 2014 and before when the models were sure the boundary would show up around 5.5%. This is no small miss.

And it is supposed to have been a very good one. After all, if you think that the exceptionally positive mechanics of recovery are going to be shut off when unemployment reaches ~5.5% of the labor force, only to find that they weren’t and after several more years the rate has come down to 3.7% (at its lowest), how could this be anything but really good?

The only negative scenario is the one where the unemployment rate doesn’t matter. In that case, depending upon it for predicting the state of the economy would lead one quite astray.

If you go back and review the transformation of Economics over the last four decades, what you find, especially in the context of central banking, is this emphasis on forecasting. Central banks used to be quite simple; they would intervene in money whenever they saw monetary conditions outside preset constraints. They did so without the need nor desire to forecast economic factors simply because it wasn’t necessary.

When money supply was high, inflationary pressures. When it was low, disinflation and the deflationary danger. Not only was it simple, central banks were kept to core competencies – banks, after all.

Moneyless monetary policy, however, has radically altered the way in which everything is set and carried out. If you can’t define let alone measure the money supply, what do you do instead? You wave your magic wand of a federal funds target and then perform all sorts of mathematical, statistical calculations that hopefully, maybe, probably suggest you are moving in the right direction.

Being so blinded, however, requires confirmation. This is where markets should be consulted frequently alongside data like the unemployment rate. Corroboration is essential. Econometric models are one-dimensional in the sense that every Economist agrees with the assumptions used to create them. They are homogenous to a fault.

It leads to this unbreakable echo chamber when contradictory information is thrown out immediately without the slightest consideration as to why. Economists pass around the results of their models to other Economists who immediately agree with them. Central bankers develop the most severe cases of tunnel vision.

On the one side, the unemployment rate suggested that inflation, even sharply accelerating inflation was nearing. Full employment means businesses are forced to compete for workers who are becoming harder and harder to find. Firms never absorb those costs if they can pass them along to their customers. The end result is rising consumer prices (Phillips Curve).

If you had been expecting inflation to show up at 5.5% unemployed, what kind of inflation would you expect at 3.7%? Surprisingly, the answer, at least in December 2018, has been changed to “muted.”

In its latest minutes published for its meeting last month, the FOMC didn’t shift its narrative so much as completely rewrite the thing. The unemployment rate has spent years falling much less than what was thought to be full employment, even so now there’s abruptly resignation in place of reassurance:

“Against this backdrop, many participants expressed the view that, especially in an environment of muted inflation pressures, the Committee could afford to be patient about further policy firming.”


“Some participants cited a weaker near-term trajectory for economic growth or a muted response of inflation to tight labor market conditions as factors contributing to the downward revisions in their assessments of the appropriate path for the policy rate.”

This year, 2019, begins in a one hundred-eighty degree opposite direction from the way 2018 began. Then, it was conventional “wisdom” that 3.7% meant what it meant; not only was the economy about to get good for the first time in a decade it was going to be so good that the Fed and Jay Powell would be forced to act far more quickly than the snail’s pace they had been operating at up to then.

It would lead to a bond market massacre the likes of which we’d not seen since 1994 if ever. This was all predicated on the unemployment rate alone.

People are suddenly interested in US Treasuries (bond market) and its yield curve if only because they think it a recession indicator. There’s a very good chance, as my colleague Joe Calhoun points out, correctly, I believe, if a recession does develop this year it may do so without the yield curve inverting this time at all (at least in the 2s10s where everyone is looking).

The curve was far more useful last year and the year(s) before. We live in a probabilistic world, rather than a purely deterministic system. The latter is the simple unemployment rate view; If X, then Y; If full employment, then inflation. In the old days when central banks focused on money, it was almost that simple. Coming in closer to the source there was fewer potential for big misses (or what they call “exploding errors” in fractal geometry).

The bond market curve, however, goes like this: If X, maybe Y.  Its shape and altitude tell us how likely Y is to result from X. When inflation hysteria was at its utmost toward the end of 2017, nominal rates did rise somewhat at the long end. However, the curve itself dramatically flattened as that happened, a confluence of factors that all go into consensus about this probability.

A flattening yield curve rising up nominally meant that Yellen and the FOMC may be right about inflation and recovery, but it still wasn’t all that likely (flattening at 3% said so; if the curve had been flattening at 6%, we’d be buying up land next to Mount Rushmore so as to carve Ben Bernanke and Janet Yellen’s faces into it). That’s the only thing that changed from the last downturn in 2016. Then, the utterly collapsed yield curve said there was almost no chance the official narrative was right about inflation and recovery using the unemployment rate.

The market action this last December has pushed the probability spectrum quite far back in the direction of 2016. And now the FOMC minutes declare officials are moving that way, too.

None of this is brand new, the real frustrating aspect. This process, as I point out so often, has repeated four times the last eleven years. It has also surprised officials in the pre-crisis period, too.

Overshadowed by “unexpected” monetary disaster in 2008, the panic was actually foreshadowed by the yield curve as early as 2005. Alan Greenspan, in the twilight of his tenure, testified to Congress in February of that year about the bond market’s “conundrum.”

He had raised the federal funds rate 150 bps by then, six 25 bps hikes at six successive FOMC meetings (ten more would follow), and longer-term Treasury yields were actually lower during them.

“This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields.”

Sounds really familiar, doesn’t it? But all Economics is plagued by “other things being equal.” They never are, we don’t live in that deterministic kind of world.

But Greenspan’s and now Powell’s conundrum starts well before any of that. Economists don’t understand bonds. They just don’t get them, the Fed Chairman’s 2005 testimony under oath more proof:

“The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year U.S. Treasury notes even if the more-distant forward rates remain unchanged. Historically, though, even these distant forward rates have tended to rise in association with monetary policy tightening.”

This sounds legitimate and he’s the “maestro”, so nobody was going to challenge this. It is actually Greenspan spelling out for US Senators he has no idea how a yield curve works. This is no trivial intellectual deficit. A series of one-year forward rates? Who thinks like that? Not anyone who has ever invested, that’s for sure.

But in the world of econometrics, interest rates and curves must be decomposed in this fashion else the math is incapable of resolving the necessary equations. To recognize reality would leave any statistical model riddled with open-ended variables, therefore infinities. The math breaks down. Rather than solve the problem more realistically, Economists simplify variables to the point of being unrecognizable to the real world.

Predictably, policymakers have trouble with the real world.

The yield curve is not a deterministic set of escalating forward rates. It is, actually, the marriage and often separation of two very different parts. In Greenspan’s orthodox view, as he says, the Fed sets the start and the whole curve moves as a consequence; If X, then Y.

The bond market just doesn’t function that way because central bankers haven’t (yet) realized they just don’t matter that much. Centralizing monetary policy makes for a nice model but not a realistic one.

The long end of the yield curve is set by mostly economic factors, perceptions of real economy opportunity as well as risk – not just credit risk, but in certain environments liquidity risk even more so. Despite claiming to use a Wicksellian/Fisherian format of understanding, Greenspan through Bernanke and Yellen to now Powell have clearly forgotten the wisdom of Knut (Wicksell).

“The rate of interest is never high or low in itself, but only in relation to the profit which people can make with the money in their hands, and this, of course, varies. In good times, when trade is brisk, the rate of profit is high, and, what is of great consequence, is generally expected to remain high; in periods of depression it is low, and expected to remain low.”

If we fashion that view through Keynes’ liquidity preference observations, we end up with a far more realistic framework for understanding financial curve dynamics than “Fed does, market obeys.” If the economy is good (Wicksell) and is expected to remain that way (Keynes) then and only then will interest rates rise. Banks, the largest piece of the bond market, will part with their safe, high liquidity instruments in favor of real economic opportunities when the probabilities turn favorable.

To Greenspan, banks are slaves to his forecast. If the Fed is raising rates, how could it be any other case but a good economy expected to persist? After all, that’s the reason for the rate hikes in the first place.

Therefore, the bond market conundrum is no conundrum at all. It is the long end realizing just how fallible central bankers are and central bankers refusing to admit that very possibility.

Those operating at the short end may know it, too, but the central bank offers monetary alternates at rates set for non-economic reasons. Powell may be hiking rates at the short end, influencing those alternatives more than economy opportunities, and he may believe that he is right about why he is doing so, but central bank models have shown they aren’t really to be relied upon. Forecast error isn’t just prominent, it’s a common feature.

In August 2014, then Federal Reserve Vice Chairman Stanley Fischer flew over to Scandinavia so he could admit to a Swedish audience what he wouldn’t, apparently, to an American one.

“Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back. Indeed, research done by my colleagues at the Federal Reserve comparing previous cases of severe recessions suggests that, even conditional on the depth and duration of the Great Recession and its association with a banking and financial crisis, the recoveries in the advanced economies have been well below average.”

The following year, 2015, was supposed to change all that. It didn’t, obviously. The FOMC, still using the unemployment rate even after economic experience in 2015, just moved on to 2017 as if none of it ever happened. It’s an entirely unscientific process of tunnel vision.

And it’s weird how it has played out up to 2019. The longer it goes without being corroborated, the more insistent Economists become how it has to be true. The more time disproves the theory, the more determined they get for its proof; winnowing down all acceptable evidence to whatever even a single factor which might be consistent. In late 2018, the only economic and market data that existed in the official universe was the unemployment rate.  

Now inflation pressures are “muted”, what’s left? Richard Feynman.

“In general we look for a new law by the following process. First we guess it. Then we compute the consequences of the guess to see what would be implied if this law that we guessed is right. Then we compare the result of the computation to nature, with experiment or experience, compare it directly with observation, to see if it works. If it disagrees with experiment it is wrong. In that simple statement is the key to science. It does not make any difference how beautiful your guess is. It does not make any difference how smart you are, who made the guess, or what his name is – if it disagrees with experiment it is wrong. That is all there is to it.”

There is no conundrum. There wasn’t in 2018, 2005, or at any point in between. They have it all wrong, and I mean ALL; from big economy stuff right down to money and curve ignorance. The only way Greenspan’s total blackout could work and continue on for so many years and so much cost (paid by you, me, and sadly our children) is the stark lack of political accountability. Independence has been a disaster, more so than activism.

While the world frets what the FOMC now confesses is “a weaker near-term trajectory for economic growth” there’s a more basic matter playing out right in the central bank’s core. Even though this particular market is barren and irrelevant, I’ve been writing about effective federal funds and IOER (the joke) for a year now. The simple reason I have is because they can’t get a handle on it.

Throughout last year, the effective rate had risen within the FOMC’s target range, making policymakers uncomfortable for the lack of margin at the top end. In June, they performed a “technical adjustment” by setting IOER 5 bps less than the federal funds upper boundary (previously it had been set equal to it). In December, a second now putting IOER 10 bps underneath.

Like QE, if you have to do it twice it didn’t work. The FOMC minutes for December 2018 therefore record more flailing:

“The staff reviewed a number of steps that the Federal Reserve could take to ensure effective monetary policy implementation were upward pressures on the federal funds rate and other money market rates to emerge. These steps included lowering the IOER rate further within the target range, using the discount window to support the efficient distribution of reserves, and slowing or smoothing the pace of reserve decline through open market operations or through slowing portfolio redemptions.”

The cascading errors in something so simple and rudimentary as federal funds mirrors those in the bigger picture of the unemployment rate, wage-driven inflation, and ultimately an economy “unexpectedly” going the wrong way. As I wrote two days ago, “If the Fed can’t get the most basic little things right, what confidence in anything else? December markets are your answer.”

It’s all coming apart at the seams. If only curves were a series of one-year forwards, the easy work of simple deterministic assumptions. Instead, inflation pressures remain unsurprisingly muted. The consequences will not.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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