Is the Fed fighting last year’s battle?

Retail inventories are piling up.

Many commodity prices are declining.

There are signs the economy is slowing.

These are all indications of potential future deflation.

Yet, central banks are tightening aggressively.

On July 13th the Bank of Canada increased rates by 100 basis points. Markets are now assigning a 31% probability the Fed hikes by 100 basis points on July 27th. Up from just 7.6% probability recently.

They’re doing this to fight inflation. Released recently, prices in the US rose 9.1% over the past year, largely driven by energy which rose 41.6%. Excluding food and energy, prices rose by 5.9%. Increasing rates in an inflationary environment sounds right, but the truth is the Fed is driving while looking in the rear-view mirror. Prices TODAY are 9.1% higher than they were 12 months ago. In other words, the inflation reported today happened in the past.

I’m not saying central banks shouldn’t be tightening. Indeed, they should have started tightening long ago. I am saying that by playing last month’s, last quarter’s or last year’s game, central banks repeatedly set themselves up to make huge policy errors. In all likelihood, by pushing up rates into a bear market and a slowing economy central banks will go too far and we’ll experience a hard landing.

But what else can they do? They’re making up for lost time and must deal with the realities we all see, rather than the possibilities some anticipate.

When looking towards the future, central banks are notorious for getting it wrong. While they employ some of the smartest economists in the world, central banks have a poor track record for forecasting the very premise of their existence: inflation and economic conditions.

Just look at the Bank of Canada governor’s statement made on July 16, 2020. In it, the Bank of Canada governor promised low rates for a long time, explicitly encouraging big ticket borrowing. In this statement, the Bank of Canada governor said, “If you’ve got a mortgage, or you’re considering to make a major purchase you can be confident that interest rates will be low for a long time.”

And the following list of statements by Jay Powell illustrate how they’re consistently a step behind reality:

“I don’t think it’s time to taper. I don’t think it’s time to raise rates. Our policy is well-positioned to manage a range of plausible outcomes.”

– Jerome Powell October 22, 2021. 

– **September 2021 inflation rate:** 5.39%

“We understand the difficulties that high inflation poses for individuals and families… Let me say that what’s happened, is that inflation is coming higher than expected. We see that just like everyone else does, and we see that they’re now on track to persist well into next year… I do think it would be premature to raise rates today.”

– Jerome Powell November 3, 2021.

– **October 2021 inflation rate:** 6.22%

“The word ‘transitory’ has different meanings to different people. It’s a confusing word that needs to be  retired.”

– Jerome Powell November 30th, 2021.

– **October 2021 inflation rate:** 6.22%

“I’d say that the inflation situation is about the same or slightly worse… It hasn’t gotten better and that’s been the pattern… What we’re learning is it’s just taking much longer, and that raises the risk that high inflation will be more persistent.”

– Jerome Powell January 26th, 2022.

– **December 2021 inflation rate:** 7.04%

“The inflation that we are experiencing is just nothing that we have experienced in decades… All the things we did during the pandemic, we turned our dials as hard as we could… Part of what we did and what Congress did is the reason why inflation is so high.”

– Jerome Powell March 2nd, 2022.

– **February 2022 inflation rate:** 7.87%

“The rise in inflation has been much greater and more persistent than forecasters generally expected… We’re not expecting near-term progress on inflation.”

– Jerome Powell March 21st, 2022.

– **February 2022 inflation rate:** 7.87%

“It is appropriate in my view to be moving a little more quickly… We had an expectation that inflation would peak around this time and then come down over the course of the rest of the year. These expectations have been disappointing in the past and now we want to see actual progress… Are we going back to the old economy? Probably not. What’s the new one going to look like?”

– Jerome Powell April 21st, 2022.

– **March 2022 inflation rate:** 8.54%

“We have a good chance at a soft or softish landing… There’s a false precision in the discussion that we as policymakers don’t really feel… the economy is doing fairly well… I think we have a good chance to restore price stability without a recession.”

– Jerome Powell May 4th, 2022.

– **April 2022 inflation rate:** 8.26%

“I have said, and I will say it again, if you had perfect hindsight, you’d go back and it probably would have been better for us to have raised rates a little sooner… So the question whether we can execute a soft landing or not, it may actually depend on factors that we don’t control.”

– Jerome Powell May 12th, 2022.

– **April 2022 inflation rate:** 8.26%

“We all read the inflation reports very carefully, and look for details that look positive, but truthfully, this is not the time for tremendously-nuanced readings of inflation… Sometimes the landing is just perfect, sometimes it’s a little bumpy. It’s still a good landing, you don’t even notice it… There could be some pain involved in restoring price stability, but we think we can sustain a strong labor market.”

– Jerome Powell May 17th, 2022.

– **April 2022 inflation rate:** 8.26%

“We’re not trying to induce a recession now, let’s be clear on that. We’re trying to achieve 2% inflation and a consistently strong labor market… We think that the public generally sees us as very likely to be successful at getting inflation down to 2%.”

– Jerome Powell June 15th, 2022.

– **May 2022 inflation rate:** 8.60%

“The American economy is very strong and well-positioned to handle tighter monetary policy… It is a possibility our rate rises could cause a recession… We’re not trying to provoke and don’t think that we will need to provoke a recession.”

– Jerome Powell June 22nd, 2022.

– **May 2022 inflation rate:** 8.60%

“During the summer months of 2021, inflation was coming down month-by-month. So that told us that our thesis that this was going to be a passing inflation shock was at least plausible… We did underestimate it, we clearly did… In hindsight, it [inflation] was not transitory.”

– Jerome Powell June 23rd, 2022.

– **May 2022 inflation rate:** 8.60%

“We now understand better how little we understand about inflation. This was unpredicted… We fully appreciate the pain people are going through.”

– Jerome Powell June 29th, 2022.

– **May 2022 inflation rate:** 8.60%

I have the advantage of being an armchair quarterback. July 2020 honestly felt like the economy – including the housing market – was going to implode so I get why central bankers encouraged people to borrow and spend and thought inflation would remain tame for a long time.

You can also see how their views slowly evolve over time. Powell went from transitory to not transitory, strong economy to soft landing to we’re crossing our fingers we don’t plunge the economy into the depths of hell. These statements are simply a reflection of the mainstream consensus thinking at a point in time, so don’t take it as anything more. They certainly have little forecasting value. By the time Powell states we’re in a recession, everyone will already know we’re in a recession.

I don’t blame them. Forecasting is very difficult because of the infinite number of variables involved, including irrational human behaviour.

Moreover, central banks have a lot of influence over markets and therefore can’t be seen as shaping market direction. For this reason, central bankers sweat over every adjective and adverb in their statements to avoid swaying the market one way or another, allowing the market to incrementally absorb gradual shifts in monetary policy over time.

At best, Fed policy and statements are a reflection of the immediate situation – a coincident indicator reacting to the data of the day. The data for today is 9.1%, leaving us with a central bank struggling to catch up to fight last year’s battle.

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    Excellent post. “’It’s tough to make predictions, especially about the future’” – Yogi Berra.
    In 2020 the focus was on saving the economy, now the focus is saving the savings.