The Market And The Fed

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by: Scott Sumner

Stephen Williamson recently made this observation:

As a side note, I thought the part of the FOMC discussion where the staff gives a presentation relating to an alternative indicator - the difference between the current fed funds rate and what the market thinks the future fed funds rate will be - was good for a chuckle. If the FOMC thinks the market knows more about what it's going to do than what it knows about what it's going to do, we're all in trouble.

I have the opposite perspective; we are in big trouble if the FOMC thinks it knows more than the market about what it will do to rates in the future.

Back in late 2015, the Fed began raising its target interest rate. At the time, it anticipated another 4 rate increases in 2016. Markets were skeptical, expecting only about one rate increase in 2016. In fact, rates were not raised again until the very end of 2016. That's because economic growth and inflation during 2016 were below the Fed's expectations. The markets were correct on this occasion (not always).

If you want an efficient estimate of the future path of interest rates, look at the market forecast, not the "dot plot". The dot plots are primarily useful as a measure of how deluded FOMC members are in their appraisal of the economy. Because they were too optimistic in late 2015, they set rates too high. That slowed the recovery, and probably tilted the (very close) election toward Trump. And now, to quote Williamson, "we're all in trouble".

Interest rates are now higher than in 2016, but monetary policy is actually more expansionary than two years ago. To Williamson's credit, he is one of the few economists who seems to understand how this can be possible.

HT: Tyler Cowen