I think it's safe to say that if the labor market were already shedding hundreds of thousands of jobs each month, the Fed would have stopped its rate hikes by now.
But that illustrates the problem with a central bank that sets monetary policy, which will influence the economy 12-18 months from now, based on economic data that itself reflects monetary conditions from 12-18 months ago. That's why I said on air the other day that the Fed's "dot plot"--its own members' projections of where rates will be next year--are themselves one of the biggest lagging indicators we have. All they reflect is what we already know from how the economy has performed in recent months, and have no actual predictive value.
Just look, for instance, at what the members expected last December. Their median inflation projection for 2022 was just 2.6%! They expected the fed funds rate would be less than 1% right now--a far cry from where we actually ended up, at over 4%. This is an enormous failure of predictive capacity. It was at best a coincident indicator, telling us only what we already knew at the time.
This helps to illustrate why Fed has always been so procyclical and prone to policy errors; because it keeps setting future policy based on past conditions, amplifying boom and bust cycles. Is there any way to avoid this outcome? Possibly--if they would at least give some genuine heft to market signals. Perhaps the most useful characteristic of financial markets is that they are one of the best predictive machines we have.
I'm not talking about stock prices, per se, but rather about implied future interest rates and inflation expectations based on where bonds are trading. Things like yield curves, forward "spreads," and monetary aggregates. Everyone in markets has their personal "favorite"--some like the one-year versus ten-year Treasury yield; others like to watch inflation breakevens; Fed researchers themselves have even written up the usefulness of the "near-term spread" as able to " predict four-quarter GDP growth with greater accuracy than survey consensus forecasts," as they wrote in 2018.
The near-term spread (the implied rate on Treasury bills six quarters from now versus the current yield), by the way, just recently inverted--yet another market gauge suggesting that the Fed is over-tightening. It's one thing when you have just a couple gauges flashing cautionary signals. It's another when they are all basically unanimous, as is the case right now. Aside from that spread, pretty much every other yield curve is also inverted--some deeply so. The two-year/ten-year yield gap is the deepest we've seen in forty years. "The short end is fearing they are doing too much," says John Spallanzani of Miller Value Partners.
The market's inflation expectations have also fallen way back, from a high of over 3.5% in March to 2.1% as of last week (for expected annual inflation over the next five years). A similar decline from over 3% to 2.1% has also been seen in the ten-year time horizon. This as we have witnessed a major reversal of liquidity, with the M2 money supply measure having gone from a peak of nearly 28% year-on-year growth in February of 2021--which was what fueled the high inflation readings we've recently gotten--to just 0.8% as of last month, which points to much cooler nominal growth and inflation ahead.
It would be one thing if Chair Powell or other Fed members prominently mentioned these data points as a red flag that they are heeding in terms of setting the future rate course. But they are not. Powell's hawkishness at his Fed press conference last Wednesday has sent the markets spiraling lower, with the S&P 500 already down about 5% since then.
This isn't about the Fed "getting pushed around by the stock market," or anything like that. This is about how to make the Fed a smarter leading policy setter, instead of a backwards-looking, over-correcting, error-prone central bank that could be leading us into a needlessly deep recession. If they wait for these leading indicators to show up as actual job cuts or inflation prints before slamming the brakes here it will be way, way too late.
See you at 1 p.m!
Kelly
P.S. Tomorrow at 9 a.m. I will be moderating a Brookings debate on whether and how to regulate crypto (with Stephen Cecchetti and Peter Conti-Brown!); you can register and send in questions here. Hope to see you then!
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