Beacon Economics

Based on the Fed’s track record of incomprehensible policy changes, investors should try to ignore ridiculous market head fakes.

Christopher Thornberg, PhD

Christopher Thornberg, PhD

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For all the sophistication of modern asset markets, at their core, they are still just Keynesian beauty contests. Keynes’s metaphor for the markets derived from a special type of beauty contest where the judges don’t pick who they think is most attractive, but who they think will be most attractive to all the other judges. His intuition is that traders are mainly trying to anticipate what the average trader thinks the average trader thinks is about to happen. Such nested logic can generate wild volatility in the market’s response to the silliest peices of news. This has been proven yet again in the waning days of 2023 with a big jump in equity and bond prices, all because of the odd notion that there has been a sharp pivot in Federal Reserve policy. The market now anticipates that the Fed will lower interest rates multiple times next year.

It is amazing to think that billions of dollars of asset value were generated because of this leap of faith. The problem is it is very hard to see any sign of this pivot in the Fed’s actual FOMC release. It starts by noting that “growth of economic activity has slowed from its strong pace in the third quarter,” a point that is completely obvious given that the nation is unlikely to repeat last quarter’s 5% pace. Beyond that, they make it crystal clear that their primary worry remains inflation. They are holding rates steady and more significantly (from our perspective) will continue quantitative tightening at its current pace ($90 billion per month). This has been the primary driver of the sharp slowing of bank lending in 2023, and a contributing factor to the upward tick in long run rates.

So why do markets think the Fed has pivoted? As it turns out, the idea comes from the Fed board’s semi-official economic forecast, which now accompanies their official FOMC statement. The median forecast from the various board members says that real GDP growth will slow from 2.8% this year to 1.4% in 2024. They are also anticipating a decline in the Federal Funds rate from 5.4% to 4.6%, presumably FOMC actions that would be taken in response to weakening growth trends. That’s it. The source of all the breathless news about next year’s supposed pivot and big movement in prices is one throwaway number in an add-on report. 1

So, before we pop the champagne and toast our good fortune, let’s consider the accuracy of the Fed’s informal forecast. Last December, the Fed’s economic outlook suggested real growth in 2023 would be 0.5% per quarter. The current (actual) trend is nearly 3%. In 2021, their prediction for growth in 2022 was 4% and growth turned out to be 0.6%.5 They also anticipated inflation to run just 2.6% that year—because they told us the surge in inflation was strictly transitory. I could continue, but I think the point is made—these forecasts have been wildly off base. If the Fed says “up” you better count on down.

On this basis, we can dismiss the pivot call out of hand. But of course the Fed is not the only pessimistic outlook for 2024. The Wall Street Journal’s Economic Forecasting Survey (which Beacon Economics contributes to) currently suggests that there is a 50% chance of a recession occurring in the next 12 months. But then again, in October 2022, this same survey suggested a 60% chance of a recession in 2023, with a full one-third of the contributing economists saying the odds were greater than 3 in 4. Not only did that phantom downturn fail to materialize this year, the U.S. economy looks significantly stronger today than it did when then forecasters started making these predictions.

As such, Beacon Economics’ outlook is not changing much. We are pessimistic about rates because of our optimism about the U.S. consumer. Consumer strength means higher prices, and this, in turn, means the Fed will not pivot. We anticipate 2024 to be a year in which credit markets remain tight, interest rates stay higher than current predictions, and the economy keeps on growing (albeit at a slower pace than in 2023); bad news for all the people hoping for bad news.

Still, there is one other issue to keep in mind and that is the Fed’s recent track record of making economically incomprehensible changes in policy. Their record implies that there is a positive probability the Fed might indeed cut rates next year, despite a growing economy and hotter than anticipated inflation rates. But that probability is much lower than what is being built into the current leap in asset prices. Investors should, as best they can, try to ignore these ridiculous market head fakes.

Finally, all of this shouldn’t suggest that everything is fine with the U.S. economy. The nation still has to grapple with the Federal deficit, asset prices remain highly overvalued, and credit markets remain very tight. All of these things will become important economic issues at some point, but we don’t see them becoming toxic enough over the next two years to sink the expansion. Worst of all, our political leaders (including Jerome Powel and the FOMC) seem to inhabit a world very different than the one evidenced in the data. The dominant political narratives and policy priorities remain deeply flawed.

(1) Since Ben Bernake was the Federal Reserve Chairperson, members of the FOMC board each provide their own forecast for inflation, real growth, the unemployment rate, and the Federal Funds rate. With each FOMC policy release, they release a table that shows the median result of these forecasts. This is different than the official Federal Reserve forecast.


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