Average Inflation Forecasting Credibility

Fed forecasts, inflationary debt imbalances, labor demand and supply, earnings wrap.

We apologize for the delayed note this week. Be on the lookout for the weekly podcast summary Monday morning.

AIFC

On a call Tuesday morning we were asked about the risks associated with the post-FOMC speech calendar. What jumped off the screen was the absence of speeches from the leadership, that is the Chair, Vice Chair and NY Fed President. One of our primary conclusions from last week’s meeting is the Fed is out of the forward guidance business — Fed Governor Bowman was definitive about this policy change in a speech over the weekend. Consequently, all those speeches would offer were forecasts from FOMC participants. The organization has regained credibility in terms of the inflation portion of their mandate, but they have not regained forecasting credibility from the transitory inflation episode. The forecasting credibility gap does not seem to have stopped the Bank of England from making an astounding recession forecast. The press was buzzing with the BOE’s expectation of a 5 quarter, 2.1% GDP drop beginning in 4Q21, but we found it humorous. The markets looked past FOMC participant forecasts, as they should, because average inflation forecasting credibility is, in statistical terminology, approaching zero. Clearly, we are embellishing to make a point that is integral to our monetary policy framework. Rather than parsing every Fed speech, we analyze their reaction function and develop our own forecasts. For example, we are not counting on FOMC participants to talk the market out of the rate cuts in 2023, with all due respect to Minneapolis President Neel Kashkari, whose view we agree with. Instead of depending on Fed forward guidance, our inflation scenario analysis implies an inflation floor around 4% and the obvious policy implication is the FOMC is unlikely be cutting rates in 2023. The trade we like to capitalize on our view they will hike marginally less than expected in ‘22 due to inflation falling towards 4% but stalling in ‘23, is a December ‘22, December ‘23 Eurodollar steepener (long EDZ2 at 4%, short EDZ3 at 3.31%).

Figure 1: While 225bp of hikes in four months is a lot, policy is looser than it was in late 2018. The policy setting bordered on absurdly lose in 2021. FOMC participants often admit to being late to beginning to normalize policy, we haven’t heard any admission they may have overdone it. This is important for investors; the starting point is critical to understanding the risks they go too far.