Have bad calls eroded the credibility of Central Banks?
Just over a year ago, the US Federal Reserve said inflation was ‘transitory’. Six months later, it said it would not need to raise interest rates above zero. Yet, just last week at its May meeting, the Fed announced it would need to raise rates 0.50 per cent in the face of soaring and persistent inflation. Is it any wonder many people feel the Fed is out of touch, and have lost faith in its policies and prognostications?
Almost immediately after COVID-19 put Earth into lockdown, central banks globally began cutting rates to near zero. The US Federal Reserve, upon whom everyone has an eye, also commenced purchasing US$120 billion worth of US Treasury bonds every month. It was an aggressive albeit necessary response.
At the time of the stimulus, and perhaps because of its necessity and urgency, little thought appeared to be devoted to the impact on markets and economies of its reversal. Perhaps fear over some of the possible scenarios meant, as the economy began recovering, the US Fed maintained its aggressive posture, keeping rates at zero and its foot firmly on the bond purchasing accelerator.
In 2021, even as inflation surged beyond the Federal Reserve’s initial and subsequent estimates, it maintained its aggressive posture. The Fed’s faith in the transitory nature of current inflationary influences is unshaken, but the extent of its acceleration is enough to cause short-term expectations to leak into changing behaviour associated with high long-term inflation expectations. And it is that which central banks must respond to.
I have previously cited the Fed’s April 21 statements regarding inflation and its “likely” transitory characteristics.
On April 28, 2021 the US Federal Reserve’s Chairman Jerome Powell commented:
“In the United States, fiscal and monetary policy continue to provide strong support. Vaccinations are now widespread, and the economy is beginning to move ahead with real momentum. During this time of reopening, we are likely to see some upward pressure on prices…But those pressures are likely to be temporary as they are associated with the reopening process. In an episode of one-time price increases, as the economy reopens, is not the same thing as, and is not likely to lead to persistently higher year-over-year inflation into the future – inflation at levels that are not consistent with our goal of 2 per cent inflation over time.”
Clearly, the Federal Open Market Committee (FOMC) was aware of the perils of inflation but its dual mandate, which includes the fostering of strong employment conditions, was perhaps also responsible for a sanguine view. In June last year, the median FOMC participant projected that the federal funds rate would remain at its effective lower bound through the end of 2022. And as recently as September, more than half of the FOMC’s members still believed rates would remain at zero through 2022.
Central bankers are not blessed with the ability to see the future. They are as beholden to historical data as we are, and yet they are required to make real-time decisions piloting economies through an uncertain future.
In March of this year, Jerome Powell had this to say about US inflation;
“Turning to price stability, the inflation outlook had deteriorated significantly this year even before Russia’s invasion of Ukraine.
“The rise in inflation has been much greater and more persistent than forecasters generally expected. For example, at the time of our June 2021 meeting, every Federal Open Market Committee (FOMC) participant and all but one of 35 submissions in the Survey of Professional Forecasters predicted that 2021 inflation would be below 4 per cent. Inflation came in at 5.5 per cent.
“For a time, moderate inflation forecasts looked plausible—the one-month headline and core inflation rates declined steadily from April through September. But inflation moved up sharply in the fall, and, just since our December meeting, the median FOMC projection for year-end 2022 jumped from 2.6 per cent to 4.3 per cent.
“Why have forecasts been so far off? In my view, an important part of the explanation is that forecasters widely underestimated the severity and persistence of supply-side frictions, which, when combined with strong demand, especially for durable goods, produced surprisingly high inflation.”
In the absence of both perfect information and perfect foresight, the US Fed is determined to reverse its unprecedented and nonconventional monetary stimulus to bring down inflation without causing a recession. The Fed is attempting to steer the US economy (and the rest of the world with it), to a soft landing. Indeed, Powell stated as much in March:
“Some have argued that history stacks the odds against achieving a soft landing, and point to the 1994 episode as the only successful soft landing in the postwar period. I believe that the historical record provides some grounds for optimism: Soft, or at least soft-ish, landings have been relatively common in U.S. monetary history. In three episodes—in 1965, 1984, and 1994—the Fed raised the federal funds rate significantly in response to perceived overheating without precipitating a recession.”
The only problem with this selective analysis is it ignores the periods rate rises were followed by recessions. And of those there are many more. In the late 1950s, the late 60s, early 70s, early 80s, late 80s, late 90s and early 2000s rate rises were followed by or triggered recessions.
Some three-quarters of rate hikes were followed by recession. In other words, the Fed’s Powell asks us to be hopeful. Hope of course is not a strategy and so investors might be wise to look askance at any central bank claim it has everything, or anything, ‘in hand’.
And of course, in the past, the Fed did not have to contend with a Ukraine war, geopolitical instability in Asia, and a COVID-Zero policy in China.
Little more than a year ago, the Fed said inflation was transitory. Six months ago the Fed signaled rates would remain at zero to maintain strong employment conditions. And today we are asked to believe in soft landings.
Unprecedented demand for labour however will likely mean the unemployment rate will continue to decline and conditions tighten. The soft landing scenario may soon give way to a rate policy that must move above neutral and towards restrictive.
Such a scenario of course could mean further compression in PE ratios.