Revenge of the dots. Sort of. The Federal Reserve hit the pause button for the second time this year this week, yet all anyone wanted to talk about was next year. Maybe there will be another rate hike from policymakers in 2023, maybe not. What comes immediately afterward, and why, that’s the whole thing.
And it isn’t inflation. That much we might agree on.
Fed Chair Jay Powell told reporters on Wednesday they understand substantial headway has been made on consumer prices. The numbers are all distinctly disinflationary even if yearly rates have ticked back up the last couple months thanks to our “friends” in Saudi Arabia. Supply-restrained oil is far more likely to tip the economy (further?) into recession – as it has repeatedly before – than it is to generate Great Inflation 2 (because that’s not how inflation works).
The Summary of Economic Projections, forecasts drawn from individual branch presidents and board members, or, really, their staffs, showed the median fed funds target at 5.1% for 2024 compared to 4.6% in June. The same half-point increase was applied to 2025, bringing that one up to 3.9% from 3.4% previously.
These are the infamous dots.
Yes, officials want to see more and see it through all the way, though that’s not what jumped rate expectations for 2024. Responding to Financial Times reporter Colby Smith, Powell noted:
“Clearly what we decided to do is maintain the policy rate and await further data. We want to see convincing evidence, really, that we have reached the appropriate level, and we're seeing progress, and we welcome that. But we need to see more progress before we'll be willing to reach that conclusion.”
Many are calling it higher for longer when it is instead the natural endpoint of the soft landing belief. Again, Powell classified it specifically as economic resilience:
“…we've seen inflation be more persistent over the course of the past year, but I wouldn't say that's something that's appeared in the recent data. It's more about stronger economic activity, I would say. So if I had to attribute one thing, again, we're picking medians here and trying to attribute one explanation, but I think broadly stronger economic activity means we have to do more with rates, and that's what that meaning is telling you.”
The previously lower dots were participants forecasting recession, as many had up to recently, and projecting accordingly. Should the economy falter badly enough, everyone knows, including the FOMC’s members, rates would be lowered.
Now that they think the economy is in the clear, no need for reductions this year, next year, maybe not until 2026 when at some point policymakers will cut rates because eventually they will need to be closer to their longer run potential.
Whatever that might be. No one is entirely sure what policy rates even signify, if anything special, right now. It’s all a big crapshoot as the Chair himself disclosed:
“In terms of what the neutral rate can be, you know, we know it by its works. We only know it by its works, really. We can’t – we can’t - the models that we use, ultimately you only know when you get there and by the way the economy reacts, and, again, that's another reason why we're moving carefully now because, you know, there are lags here.”
For the current worldview among Economists inhabiting central banks, the neutral rate is everything. It doesn’t just guide their efforts; the number dictates the very essence of the policy. Come out on the wrong side of it and by this theory what you think is a tight one might in reality be loose.
The neutral rate is the theoretical level at which there is no impact on the economy. If whatever yield in question is close enough to the concept, it would neither mean credit is “too” expensive nor “too” cheap. Calling it Goldilocks is being too kind.
As important as this thing is for them, you’d think authorities and academics would have a keen grasp on it, or at worst some solid clues about its location. Nope.
Instead, like everything else central bankers do, they model macroeconomic variables and extrapolate them forward. They take today’s unemployment rate and CPI then “calculate” what those should be in a few quarters or next year. If the results come out like what officials are shooting for, then they assume today’s interest rates must be right where they want them in relation to the unobserved neutral rate.
Not quite the “quantitative” science all this is projected to be for public consumption. A better description is hoping for the best and when achieving it, if ever, merely claiming credit and making the numbers work after the fact.
This weird process made its debut in 1993 out of frank necessity back when Alan Greenspan’s Fed finally and formally abandoned money supply as a means to maintain or even judge monetary policies. In practice, officials had done this many years before; the difference in ’93 was the Fed’s Chairman conceding it in public.
The shift came out, ironically, during the second of his semi-annual Humphrey-Hawkins required Congressional appearances that year. It was deeply ironic because that law passed in 1978 during the Great Inflation (when even Congress! realized inflation was money) specifically required the Fed to maintain, produce, and publicize the very money supply targets Greenspan was then admitting to have deserted.
“CHAIRMAN GREENSPAN. The historical relationships between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place.”
Unable to come up with any, or even some realistic candidates (which was supposed to have been M3, by the way, but the eurodollar system was too complex and shadowy for the always-behind technocrats to have ever caught up to it), Greenspan quite out of necessity turned to Wicksell and a whole lot more random luck then you’ve ever been let in on.
This paradigm shift was unmistakable here even if the “maestro” almost certainly intentionally obscured the reference by employing the term “equilibrium interest rate”:
“CHAIRMAN GREENSPAN. In assessing real rates, the central issue is their relationship to an equilibrium interest rate, specifically the real rate level that, if maintained, would keep the economy at its production potential over time. Rates persisting above that level, history tells us, tend to be associated with slack, disinflation, and economic stagnation–below that level with eventual resource bottlenecks and rising inflation, which ultimately engenders economic contraction.”
For policy purposes, should central bankers choose to induce such “slack, disinflation, and economic stagnation” because they further presume it to be the antidote to inflation, then the real rate must get above the neutral (or natural, as Wicksell had termed it) rate.
Terrific. It sounds incredibly simple and straightforward, and it would be except, again, no one has a clue what the natural rate is. Like Powell this week, Chairman Greenspan thirty years ago admitted it wasn’t observable and only tenuously projected. However, he claimed they didn’t necessarily need to be precise:
“CHAIRMAN GREENSPAN. The level of the equilibrium real rate – or more appropriately the equilibrium term structure of real rates – cannot be estimated with a great deal of confidence, though with enough to be useful for monetary policy.”
For an agency that intentionally gives off the vibe of being able to achieve high degrees of accuracy (quantitative easing, anyone?), here is the institution’s current intellectual founder declaring rate targeting down on the horseshoes and hand grenades level.
Close enough will do!
But, Greenspan countered, though money supply aggregates were utterly useless the Fed did have some other indications to lean on for at least some confirmation. If assertions were correct, that the current term structure of real rates was where policymakers wanted them in relation to the equilibrium (neutral) term structure, officials would be able to check their assumptions against other sources.
In the case of ’93, the Chairman noted, “Currently, short-term real rates, most directly affected by the Federal Reserve, are not far from zero; long-term rates, set primarily by the market, are appreciably higher, judging from the steep slope of the yield curve and reasonable suppositions about inflation expectations.”
Ah, the bond market.
Before 2005’s “conundrum”, Dear Alan looked more favorably upon it. But what if the slope of the yield curve disagrees? Well, that was the whole point behind that infamous term.
In the current case, the potential remains though not necessarily about policy targets, more so economic and financial outcomes. We all know the curve is inverted and has remained so in some places along it by a record amount of time. Yet, the Fed fears neither recession nor inflation.
At least on the latter the market and the central bank do agree if then immediately going their separate ways from there. Why, then, does the market continuously price little chance for soft landing where the Fed only sees one?
One partial answer is itself credit. This, like the equilibrium or natural rate, is yet another model blind spot. Believe it or not, the Fed’s or any mainstream DSGE model doesn’t directly input debt or finance. There have been some belated attempts to incorporate them, though to what progress?
Instead, the official forecasts presume if credit is having a negative impact they’ll somehow pick it up maybe secondhand such as some possible negative effects on consumer confidence (not making this up). Credit otherwise doesn’t matter unless you or I feel bad (or good) about it.
Just a few years prior to Greenspan’s Wicksell-ian embrace, in the middle of 1990 the FOMC was wrestling with the recession question and a credit crunch yet oddly came to the conclusion it was a figment of the hyperbolic press. Just after having first stated outright the Fed doesn’t model credit, staffer Mike Prell in July 1990 said this:
“MR. PRELL. I suggested that perhaps the decline in consumer sentiment might have been affected to some degree by all of the press discussion of shortages of credit and the possibly bad effects on business. That might be why consumers are less confident than they were before.”
He and others then went on to explain this was the only way they’d be able to pick up on the credit crunch becoming very evident and not just in the newspapers or nightly network reports. It only made the potential drag easier to ignore, as they all would a little while later in the discussion when another staffer, Mr. Syron, claimed, “Interestingly, the credit crunch question, although I'm not sure quantitatively or qualitatively that it has gotten any less pressing one way or the other, is becoming much less newsworthy and is drawing much less attention.”
For the record, the recession had already begun while this meeting was taking place, the NBER in April 1991 declaring a cycle peak at June 1990. Furthermore, the credit environment the stats in 2023 are drawn from is already more severe than it was at any point later in ’90 on into ’91 as that recession developed in the background behind the so-called Gulf War.
The Fed’s 2024 dots, as they are currently arranged, are just that; dots. Stabs in the dark with far less, if any, substance behind them apart from what anyone in the public can already themselves surmise. Everyone knows the CPIs are down, though little is known about why and what that means moving forward.
Close isn’t really close enough.