The Case For Wrong: A History Of The Federal Reserve's Projections

by: Jeff Opdyke


Minneapolis Fed Gov. Neel Kashkari agrees: The Fed should not have raised rates last week.

The Fed has history of overconfidence in the economy that rarely pans out, yet it's this confidence that drives the Fed to act.

In time, the Fed is likely to find that the recent rate hike was unwarranted.

Remain skeptical. All is not as it appears. Own gold and Treasury paper as protection.

A week ago, I took a stand. I said the Fed was not likely to raise rates. Turns out the Fed doesn't pay attention to the embattled American consumer but, rather, coddles Wall Street.

In other words, I was wrong this time.

At least I was in good company in proffering my analysis on why the Fed should have held off.

Minneapolis Fed President Neel Kashkari said after the rate hike that he, too, thinks the Fed was wrong to add another 25 basis points to the fed funds rate, as it did last week. He was the lone dissenter in the vote to raise rates.

His blog post explaining his decision makes for interesting reading because it hints at the problem I've been talking about: A disconnect between the jobs market and the broader economy, for which inflation stands in as Kashkari's bogey.

As we all know, America's low unemployment rate should equate to rising wages which, in turn, should foment hotter inflation. But as my grandfather used to tell me, "If ifs and buts were hickory nuts, we'd all have a Merry Christmas."

In short, the linkage between jobs and wages and inflation is, if not broken, severely frayed.

Which is Kashkari's point:

…The data aren't supporting this story [of tight labor markets leading to rising wages and inflation], with the FOMC coming up short on its inflation target for many years in a row, and now with core inflation actually falling even as the labor market is tightening. If we base our outlook for inflation on these actual data, we shouldn't have raised rates this week. Instead, we should have waited to see if the recent drop in inflation is transitory to ensure that we are fulfilling our inflation mandate … The risk of raising rates too soon is a continuation of the FOMC's track record of coming up short of our inflation objective.

And it's the Fed's track record I ultimately want to get to.

See, while I was certainly wrong in with my expectation that the Fed would hold off on a rate hike last week, the Fed has been consistently wrong since the end of the Great Recession. It has consistently overshot the mark in its expectations for the economy. Fed governors have expected the economy to grow faster than has actually occurred, and the governors have expected interest rates.

Take a look at this graphic I threw together (with data from the Fed itself). It's each of the Fed's quarterly predictions over time for economic growth:

Notice the obvious trend? Just about every line declines, which says that the Fed is, itself, over-exuberant about the economy. Every year, the Fed starts out with economic projections that are rosy and chipper … and every year, the economy chips away at those roses and underperforms, which is why the lines always seem to head down.

It's the same with Core Personal Consumption Expenditures, or core PCE, the Fed's preferred measure of inflation.

Consider this chart:

That's the Fed's forward-looking projection for core PCE every quarter going back to 2010. Look at all those 2% projections, which just happens to be the Fed's threshold for acceptable inflation. Every year, the Fed looks into the future and, with no rationale for doing so, projects that inflation will hit 2%...

Now, look at this chart, which I will snarkily call Reality:

Only once did core PCE top 2%, in the first quarter of 2012. Other than that … not even close.

What this says is that Fed is living in a world of wishful thinking. It's like Yellen & Co. went to a Steven Covey convention and learned that all one need do is think positive thoughts and good things will come to pass.

Alas, the economy doesn't quite work on unicorn wishes and leprechaun dreams.

The Fed, like Wall Street itself, is simply too bullish on America's near-term future. Instead of giving the economy what it needs (time to rectify debt imbalances, to deal with the partisan ignorance that has clogged up Washington and to work through the jobs vs. technology transition) the Fed is giving the Street what the Street wants: normalized interest rates (or something closer to normal). But the problem is Wall Street is simply wrong.

The US economy was doing relatively OK as it was, before the Fed hiked rates for no reason. Relatively OK. Not great. Not gangbusters. Just OK. So why mess with OK when there's no reason to?

The reason, as Kashkari hints at, is because the Fed is convinced it will be right about its 2% core PCE projection, and it wants to get ahead of that, for fear that inflation will rampage across the land like some kind of plague of grasshoppers.

It's laughable.

The jobs market, as I pointed out recently, is not all that it's cracked up to be, regardless of the lowest unemployment rate since the early Bush years. A quantity of new jobs does not replace quality. So what if we have a bazillion burger flippers and hotel clerks and whatnot? While there's nothing wrong with those jobs in terms of honest employment, they're not building a middle class … which is precisely why inflation isn't gaining any traction!

Consumers don't have the money to compete for goods, which is where inflation come from. Data from the St. Louis Fed shows that wages for nonsupervisory workers (the greatest horde of workers / consumersin America) has grown at about 1.7% since the end of the GreatRecession … roughly in line with core PCE. Wages have grown at this comparatively anemic pace because the low-skill jobs being created don't demand high-skill salaries.

Wage growth has picked up slightly in the past year, but, then again, so has the massive amount of debt Americans now carry on their personal balance sheets. We are the Indebted States of America these days, and that weighs on consumption because, given the quantity of low-wage jobs we're creating, there's only so much debt a consumer can take on before that consumer either stops spending or the house of cards crumbles … and either way, the consumer stops spending.

Certainly, a 0.25% rate hike seems trivial. But when a rate hike makes the dollar stronger (and the buck is up since the rate hike) that has implications on Corporate America's bottom line, which has implications on Main Street.

When the Fed hikes even marginally, the higher rate flows through the rates consumers pay for car-loans, credit-card balances and home-equity lines of credit … money that will end up out of the productive economy and earmarked for debt service. The ripples won't hit the opposite shore immediately, but they're on their way.

And at some point the economy will feel these impacts.

I'll wrap up with something Kashkari wrote, and which emphasizes my belief that the Fed is out of step with its rate-hike regimen:

The outcome that the current FOMC is so focused on avoiding, high inflation of the 1970s, may actually be leading us to repeat some of the same mistakes the FOMC made in the 1970s: a faith-based belief in the Phillips curve and an underappreciation of the role of expectations. In the 1970s, that faith led the Fed to keep rates too low, leading to very high inflation. Today, that same faith may be leading the Committee to repeatedly (and erroneously) forecast increasing inflation, resulting in us raising rates too quickly and continuing to undershoot our inflation target.

I continue to recommend gold and bonds as the insurance policy for tomorrow.

On the gold front, my preferred vehicle is physical gold. But if you don't want the hassle of storing gold, then look at ETFS Physical Swiss Gold Trust ETF (NYSEARCA: SGOL).

On the bond front, stick with medium-term Treasury paper, such as the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF)

I know a number of people will disagree with this analysis, arguing that the Fed must raise rates and that Wall Street isn't wrong (someone recently wrote to tell me Wall Street is never wrong). But I stand by my analysis that the US economy is structurally ill and that continued rate hikes will expose the illness in a way that unhinges Wall Street.

As always, I simply counsel preparation. The Fed is looking at the American economy through rose-hued glasses, not recognizing, as I've written before, that the tint is simply the blood spatters from the last recession and that all is not as it appears.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.