When the Fed ignores the market
By Scott Sumner
Market forecasts are often wrong. But they remain the least bad way we have of predicting the future. In the past, we’ve paid a heavy price when the Fed ignored market forecasts. In September 2008, the TIPS markets predicted very low inflation while the Fed predicted very high inflation. The Fed refused to ease money policy and we paid a heavy price when it turned out the markets were correct.
Once again the TIPS markets are predicting the Fed will fall short of its inflation target. Fortunately, this time the macroeconomic consequences of a mistake are likely to be smaller, as the economy has adjusted to 1.5% trend inflation. But it does slightly increase the risk of recession, and long term there may be a price to pay if the Fed loses credibility, or suddenly lurches toward 2% inflation at the top of the business cycle—which is the worst possible time.
Some argue that TIPS spreads are not a good indicator of inflation expectations, as TIPS are less liquid than conventional T-bonds. However there is a completely unrelated market that is sending us the same signal—fed funds futures. As the following graph shows, the market expects the fed funds rate (red line) to rise at a slower rate than the Fed estimates (blue lines.)
Notice that the market forecast for the end of 2017 is only about 1%—which is equal to the forecast of Minnesota Fed President Kocherlakota, who is viewed as being a bit eccentric by other Fed officials. That’s a warning that anyone who tells the truth about monetary policy is likely to be viewed as a bit crazy. As someone who has claimed for years that a tight money policy in 2008 caused the Great Recession, I sympathize with Mr. Kocherlakota.
As always, interest rates are tricky to interpret, as they are both indicators of policy and (endogenous) indicators of the state of the economy. As long as the Fed has at least some credibility, some intention to keep inflation in the ballpark of 2%, then long run interest rates are endogenous—they reflect the market expectation of the condition of the economy. On the other hand the Fed has some discretion about what to do this December.
If I’m right then I would interpret these market forecasts as follows:
1. The near term forecast (end of 2015) implies the market believes Fed policy will be too tight.
2. The longer term forecast (end of 2017-18) implies the market thinks NGDP will grow by much less than the Fed thinks NGDP will increase. As a result of that slow NGDP growth, the Fed will be forced to keep rates lower than it currently expects in order to prevent inflation from deviating dramatically from the 2% target. (In other words, to keep inflation in the 1% to 2% range, rather than falling into negative territory.)
As I said at the opening, markets are sometimes wrong. But if I were a betting man I’d bet on the markets, not the Fed. This is one more reason why we need policy guided by NGDP futures markets, not a committee of 12.