My Say: Why markets will keep getting the Fed wrong

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This article first appeared in Forum, The Edge Malaysia Weekly, on January 25 - 31, 2016.

 

Finally, the US Federal Reserve has seen fit to raise interest rates. It should have done it three months ago. The Fed is informally signalling that there will be another four rate increases in 2016 — “a quarter point a quarter” is the rallying cry.

Economists have been expecting this move, and as a rule, generally agree that the Fed is doing the right thing. Financial markets seem less convinced. There is an air of sullen resentment in the financial markets’ grudging acknowledgement of the Fed’s tightening. Investors in many different asset classes have been less convinced than economists about the necessity of monetary policy tightening.

So why this division between economists and markets? Why is confusion about the Fed likely to linger in 2016? There seem to be three causes of the divided opinion.

Central bank policy (at the Federal Reserve and elsewhere) has become multifaceted. Actually, central bank policy has been multifaceted for some time, but it is more apparent now. Central banks can seek to control credit through a number of different mechanisms — monetary policy, which is all about interest rates; quantitative policy, which is all about printing money; and regulatory policy, which is (obviously) all about regulation.

The potential for confusion arises because some members of the Fed may prefer to act through quantitative policy, and may sound quite dismissive about acting through monetary policy, without necessarily being dovish overall. Economists tend to think in terms of the necessity of broad central bank policy action — all three strands of policy acting in concert — while financial markets obsess over interest rates. Hence, there is potential for confusion.

The Federal Reserve also appears to be a different institution from the policy setting body that existed under Fed chairmen Paul Volcker and Alan Greenspan. That earlier era was very much a case of being led from the front (so much so that when Volcker was outvoted on policy, he promptly resigned). Anecdotally, the impression of the decision-making process of the Fed under Ben Bernanke and Janet Yellen is of a more democratic system.

Bernanke and Yellen seem to have emphasised their role in chairing the committee rather than in leading the committee, allowing a broader range of views to contend. This is not to say that the Fed is going to start behaving with the open intellectual disagreement of, say, the Bank of England.

It does mean that a wider range of views may well be expressed in public. Economists, trained in the best of academic traditions, do not find this surprising. Markets, remembering the policymaking of the earlier era, may mistake intellectual debate for policy moving in a different direction.

The final issue arises not from the Fed as an institution, nor from the structure of policymaking. The final source of division between economists and markets lies in the economic data and its interpretation. Economic data is generally being revised more often, and with larger revisions, than has traditionally been the case. This is both a cyclical and a structural issue.

The structure of the recovery at the moment is generally skewed towards smaller businesses rather than larger companies — but data on smaller businesses is sadly very limited. This means that the true nature of the recovery is rarely revealed in the initial data prints.

Furthermore, government surveys (which for the basis of the data) have larger margins of error than used to be the case, and this is also raising quality issues.

While I may be biased in my interpretation, I believe that the problem of data revision has been compounded by a deterioration in the quality of economic analysis in markets in recent years. There are fewer economists and more bloggers. This is not a combination that is likely to raise an economist’s confidence in how data is interpreted. Superficial market strategy seems to be replacing more detailed economic analysis.

Why does this matter? Financial markets tend to react to initial data released based on limited economic analysis. Economists (and most central bankers are economists) react to revised data with more in-depth analysis. With data revisions generally biased to the positive, this gives economists a more positive interpretation of the economy. Markets, looking at initial releases and ignoring subsequent revisions, have a more blinkered view.

None of this seems likely to change in 2016. I would expect that financial markets will continue to diverge from economists in their interpretation of the economy, and policy.

For investors, this can be a problem as, to paraphrase Lord Keynes, markets can remain wrong longer than investors can remain solvent. The only solution to this tricky dilemma that I can see is to employ more economists, as quickly as possible.


Paul Donovan is a global economist with UBS Investment Bank. His latest book, The Truth About Inflation,  was published by Routledge in April 2015.