Federal Reserve data dependency isn’t what it used to be.
While there is still much talk by the Fed and its representatives about how it will be guided by incoming economic data, something appears to have broken down in the calculations, with far less certainty among observers and investors over what data leads to which policy.
Time and again relatively reassuring jobs figures – most recently last week’s above-consensus payrolls – have failed to bring financial markets round to believing the Fed’s own forecasts for future interest rate hikes.
Former Fed Chair Ben Bernanke points out that the US central bank’s own forecasts for key indicators like long-term growth, inflation and interest rates have moved downward in a steady and now accelerating fashion in recent years. Whereas the Fed’s long-run projection for the federal funds rate was 3.75% in 2015, it now stands at just 3%.
These repeated failures of forecasting reflect a growing uncertainty about the economy, something which makes Fed officials far less confident in how they describe the economy and what might make them hike or even ease.
“It has not been lost on Fed policymakers that the world looks significantly different in some ways than they thought just a few years ago, and that the degree of uncertainty about how the economy and policy will evolve may now be unusually high,” Bernanke wrote in his blog for the Brookings Institute published on Monday.
“Fed communications have therefore taken on a more agnostic tone recently. In general, with policymakers sounding more agnostic and increasingly disinclined to provide clear guidance, Fed-watchers will see less benefit in parsing statements and speeches and more from paying close attention to the incoming data.”
In other words, since the Fed won’t say clearly what the data will make them do, watch the data rather than the Fed.
Investors might be excused for feeling a bit rudderless. The puzzle of the low-growth, low-inflation economy may ultimately resolve itself into patterns we can all follow, but that clearly is not now the case.
Still, the question raised by Bernanke’s advice - watch the data – is the same one Fed officials are failing to answer: watch the data and do what?
Financial market prices are data, I suppose
Fed officials themselves carry on saying they are “data dependent” but the definition of these is undergoing some subtle but significant changes. The Fed has a dual mandate of controlling inflation while fostering employment, so the economic data which is parsed most closely are those which reflect on either price changes or jobs.
That emphasis on domestic data is perhaps too narrow for a Fed which is operating in a more tightly connected global economy, and one in which financial markets are imputed to have huge power to drive or inhibit growth.
“Thus, when I reiterate that US monetary policy is data dependent, that includes not just the information gleaned from important economic releases such as payroll employment and retail sales, but also how financial market conditions react to economic and financial market developments in the global economy,” New York Fed President Bill Dudley said last week.
In other words, financial prices flashing across a screen from Shanghai or London, those are data too, and on them we are dependent.
Dudley went on to say that any further hikes this year “depends on the data, broadly defined, and, as we all know, that is not something one can predict with any accuracy.”
So, traders on global markets can push the Fed around, and there is no saying what they’ll do.
This has always been true, to a certain extent - remember the bond market vigilantes who used to punish fiscal expansion?
A dependence on financial markets remaining happy is, perhaps, the bitter fruit of the path central banks chose to get out of the worst financial crisis since the Depression. By hugely easing conditions to restore animal spirits, central banks, not least the Fed, have achieved some measure of stability and growth.
Yet they’ve created a feedback loop to which they are now subject. It isn’t so much that the Fed has a third mandate of stable and happy financial markets, as is sometimes alleged. It is rather that their ability to achieve anything close to their targets in their actual mandates is more dependent than ever on financial markets.
Financial markets, in turn, are more than ever subject to upsets from the far corners of the world.
Maybe rather than watching the data, or saying the Fed is data dependent, we ought to simply acknowledge the extent to which they are just, well, dependent.
As are we all.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
