Recent economic forecasts that have missed the mark suggest a flaw in the central bank’s approach
By James Mackintosh | March 20, 2017 10:57 a.m. ET
Currency markets offer the perfect antidote to confident forecasters. The overwhelming consensus before Christmas was that the dollar was setting off on an early-1980s-style bull run, and investors should grab hold while they still could. The euro would fall to parity, and emerging markets needed to brace for turmoil as dollar debts would become harder to service.
Three months later, the dollar’s weaker, the euro (and the less-discussed yen) is up strongly, and emerging market stocks and currencies have leapt.
Understanding what went wrong with the forecasts is vital in pinning down what might happen next. But more important for the longer term are the Federal Reserve’s predictions of weak growth forevermore—and whether it is merely projecting the recent past into the indefinite future.
There were three major drivers of the dollar’s reversal. First and probably most important was that the dollar had become a crowded trade, with pretty much everyone believing it would carry on up. Bets on dollar futures had rarely been higher, and the consensus in favour of the dollar was strong.
Underlying this positive sentiment were two fundamental arguments, neither of which has so far worked out: Central bank divergence; and U.S. tax policy.
The Fed’s December increase marked the resumption of its interrupted rate cycle, while the central banks of Europe and Japan were stuck with hopeless economies and no inflation, and so wouldn’t raise interest rates in the foreseeable future. Investors were also convinced that the Republican-controlled House proposal for a border-adjusted tax would restrict imports while helping exports, giving a boost to the dollar.
There’s a lot more at the link.
Mr Mackintosh, the author, continues to document just how far off the Fed’s economic projections have been in the recent past, and how their own (internal) recognition of their past mistakes are now leading to a bias to err again, this time on the negative side:
“All these years they’ve had these bullish views and they’ve had to downgrade,” says Stephen Jen, co-founder of Eurizon SLJ Capital. “Now just as the world economy seems to be gaining traction they are moving the other way.”
Put another way, the Fed’s economists may have fallen into the classic psychological trap of recency bias, putting too much weight on the postcrisis period. The history of secular stagnation suggests the Fed’s far from the first to assume the good times are gone forever.
It seems that the Fed hves been making the same mistakes everywhere, erring on the high side of projected economic growth — and they couldn’t even get right the “projected” GDP growth for 2016 in a meeting after 11½ months of 2016 had already elapsed — as well as the strength of the dollar. These are very different things, with very different data: GDP is a complex, after-the-fact measurement, while currency markets always have up-to-date information, but the author’s theme is that the Fed have internalized an economic bias which leads them to be wrong almost continuously.
If someone like Paul Krugman gets something wrong, people pay attention to him due to his résumé, but they still have the power to take their own decisions, and Dr Krugman has no governing power beyond his own influence. If I get something wrong, well, far fewer people listen to me, and the only people hurt by my wrong guesses would be my family and me.
But when the Federal Reserve gets things wrong, they have real power, and their wrong guesstimates have led to poor monetary policy. In a slow growth economy, one growing even more slowly than their own anemic forecasts, they have raise interest rates 50 basis points over their last two meetings, and remain on track for two more rate increases this year. That has a real, negative effect, on the margins, as far as investment and small business creation and expansion are concerned.