The Fed Is As Much In The Dark As The Rest Of Us

“The Fed Is About To Make A Massive Policy Error”

“Investor Peter Boockvar blames Fed policy ‘mistake’ for surging housing and auto prices”

“The Fed policy error that should worry investors”

“Mohamed El-Erian: The market is pricing in a higher probability of a Fed policy mistake”

Judging by the recent headlines, Jerome Powell and his fellow Federal Open Market Committee members are guilty of gross missteps in managing monetary policy and are likely to err again. Hearing the word “mistake” in a management context always brings to my mind one of the most important lessons of my MBA education: A bad outcome is not a bad decision. [1] Even if a manager makes best possible decision possible in light of the available facts, unforeseeable events may produce an unfavorable result. With the help of a friendly Classics professor, I glorified this dictum by rendering it in Latin: “Malus eventus arbitrium malus non est.”

Fairness in evaluating the Fed requires a recognition that setting interest rates to maintain stable prices without triggering a rise in unemployment is unlike many other tasks handled by government entities. Consider, for example, the task of chlorinating a municipal swimming pool. 

Errors do sometimes occur in pool chlorination, with bad consequences for swimmers. The errors arise from failing to follow established procedures that are grounded in undisputed principles of chemistry. They include adding the chlorine at a time other than peak temperature on a hot day and regularly checking the water’s pH level.  Pool managers have to deal with only a few variables to contend with and the relationships between relevant actions and the outcomes have been confirmed in millions of trials.

Interest rate policy is nothing like that. In the Fed’s century-plus existence, the Covid-19 pandemic has only one true precedent, the Spanish influenza of 1918-1919. It occurred before the advent of Keynesian fiscal policies, cost-of-living-adjustment clauses, or quantitative easing, with a composition of national output radically different from today’s.  There is no official third Fed mandate to maintain stable financial markets, yet if the Dow enters bear market territory following a rate hike, hedge fund managers and members of Congress will proclaim that the Fed blundered.

In short, there is no simple, easy-to-follow recipe for making interest rate decisions. Macroeconomics is not like chemistry or physics, where certain cause-and-effect relationships are universally acknowledged. If that were the case, the Fed’s success rate in achieving a soft landing would probably be better than its actual record of one out of the last 16 attempts. Nobody, let us hope, will seriously suggest that in the other 15 instances the FOMC incompetently failed to execute an accepted formula applicable in every circumstance, notwithstanding myriads of pertinent variables, both known and unknown.  

Cause and Effect Are Not Always Cut and Dried in Economics

If macroeconomics were reducible to Newtonian-style laws, current-year forecasts of U.S. GDP change among economists surveyed by Bloomberg would show a narrower range than +1.3% to +4.8%. The spread is even greater for this year’s CPI change—a low of +2.0% to a high of +6.3%. Against that backdrop, an accusation that the Fed made a mistake is often really a statement that the Open Market Committee members did not do what the speaker prescribed, combined with a non-falsifiable assertion (click here for more) that the subsequent recession or inflationary spike would have been avoided if they had.

It would be depressing to think that interest rates are set by fallible individuals whose appointments are politically influenced and who, out of fear that doing the right thing will have repercussions that could end up jeopardizing their independence, sometimes do the wrong thing.  The truth is much worse. No clear, bright line indicates what the right thing to do is in a particular instance, which always differs in important ways from all previous decision points. 

Given all the imponderables, investors should refrain from making large bets on analysts’ predictions that the Fed will hike rates three, four or seven times this year or that the first hike will be a quarter-point or a half-point. Such pronouncements are necessary for business reasons, but they suggest far greater precision than the facts justify.  

 [1] For a more recent indication that this lesson continues to be taught in business schools, see Good Decisions. Bad Outcomes.