"It Is A Battle Between Data And Theory" - Fed PhDs Second-Guess Inflation Model After 5 Years Of Failure

Federal Reserve officials are finally waking up to the fact that there’s something wrong with their inflation models. It only took them five years.

As Bloomberg points out, the minutes from the Fed’s July policy meeting, released yesterday, included a debate about whether the models that help the central bank set its inflation target are no longer functioning properly.

“Federal Reserve officials are looking under the hood of their most basic inflation models and starting to ask if something is wrong.

Minutes from the July 25-26 Federal Open Market Committee meeting showed a revealing debate over why the economy isn’t producing more inflation in a time of easy financial conditions, tight labor markets and solid economic growth.

The central bank has missed its 2 percent price goal for most of the past five years. Still, a majority of FOMC participants favor further rate increases. The July minutes showed an intensifying debate over whether that is the right policy response.”

Some economists worry that if the Fed begins to publicly question their methods, it could ruin what little credibility the central bank has left.

“These minutes to me were troubling,” said Ward McCarthy, chief financial economist at Jefferies LLC in New York. “They don’t have their confidence in their policy decisions; and they don’t have confidence that they can provide the right kind of guidance.”

Of course, Fed officials did everything in their power to communicate that these questions were being raised by a small minority on the FOMC, and didn’t represent anything resembling an official opinion.

“In several passages, the minutes asserted that “most” officials were sticking with a forecast that higher inflation would eventually show up. However, the debate over resource slack models and whether standard data sources were telling them the whole story also showed convictions about their forecast are fraying.”

As Bloomberg explains, prices have been resistant to any upward movement even as the US unemployment rate has fell to a 16-year low of 4.3 percent in July. The U.S. consumer price index rose 1.7 percent for the 12 months ending July, while the PCE price index, the Fed’s preferred measure, which is tied to consumption, rose 1.4 percent in June. Another gauge calculated by the Dallas Fed, which trims index outliers to highlight the underlying price trend, rose 1.7 percent for the 12 months ending June. That was the same as May, which was down from 1.74 percent in April.

A few officials pointed out what many investors have believed for years: That the Fed"s inflation forecasting model is totally useless.

“The minutes said “a few” officials described resource slack models as “not particularly useful” while “most” thought the framework was valid.

Members also questioned whether there’s another theory that might better explain the inertia in prices.

The committee also pondered a number of theories as to why inflation wasn’t responding to tightening labor resources, such as “the possibility that slack may be better measured by labor market indicators other than unemployment.”

One notable economist described it as “a battle between data and theory.”

“It is a battle between data and theory,” said Ethan Harris, head of global economic research at Bank of America Corp. in New York.

But it almost doesn’t matter that the Fed’s vaunted inflation models no longer make any sense, because, the Fed is going to keep hiking no matter what now that the risks have struck the “appropriate balance” – at least that’s what one member of the leadership (probably Chairwoman Yellen) believes.   

“The minutes also included an unusual signal that someone - possibly a member of the committee’s leadership - saw additional rate increases as striking the “appropriate balance” on policy goals, dedicating two sentences to the views of “one participant.”

“That seems like an awful lot of air time as well as a very definitive answer coming from a mere ‘one participant’ - unless that single person happened to be someone really important - like, I don’t know, maybe the Chair?,” Stephen Stanley, chief economist at Amherst Pierpont Securities in New York, wrote in a note to clients, referring to Janet Yellen.”

Maybe in whatever model they concoct to replace this one, the Fed should include a metric probably more relevant today than economists realize: The amount of time Americans’ spend on Instagram per day.
 

Why Robert Shiller Is Worried About The Market

The last time Robert Shiller heard stock-market investors talk like this in 2000, it didn’t end well for the bulls.

As Bloomberg reports, Shiller says when markets are as buoyant as they are now, resisting the urge to pile in is hard regardless of what else might be happening in society.

“I was tempted to do it, too,” he says. “Trump keeps talking about a new spirit for America and so you could (A) believe that or (B) you could believe that other investors believe that.”

What Shiller will say now is that he’s refrained from adding to his own U.S. stock positions, emphasizing overseas markets instead. One factor that makes him cautious on American shares is the S&P 500’s cyclically-adjusted price-earnings ratio: While the metric is still about 30 percent below its high in 2000, it shows stocks are almost as expensive now as they were on the eve of the 1929 crash.

Shiller is not alone.

“I don’t generally call the entire market wrong -- investors are very smart, highly motivated individuals -- but I find it hard to say why stock markets are so un-volatile right now," says Nicholas Bloom, a Stanford University economist who co-designed the uncertainty gauge with colleagues from the University of Chicago and Northwestern University.

For Hersh Shefrin, a finance professor at Santa Clara University and author of a 2007 book on the role of psychology in markets, the rally is just another example of investors’ remarkable penchant for tunnel vision. Shefrin has a favorite analogy to illustrate his point: the great tulip-mania of 17th century Holland. Even the most casual students of financial history are familiar with the frenzy, during which a rare tulip bulb was worth enough money to buy a mansion. What often gets overlooked, though, is that the mania happened during an outbreak of bubonic plague.

“People were dying left and right,” Shefrin says. “So here you have financial markets sending signals completely at odds with the social mood of the time, with the degree of fear at the time.”

But while the academics can look back and study and reflect on the nature of bubbles, the Wall Street types will always find excuses:

“It’s been a period of repeated shocks, and I think people get toughened against that,” Ethan Harris, Bank of America Merrill Lynch’s global economist in New York, says. “It seems like uncertainty is the new norm, so you just learn to live with it.”

We leave it to Mr. Shiller to sum it all up...

“The market is way over-priced," he says. "It’s not as intellectual as people would think, or as economists would have you believe."

Trade accordingly.