Does the Rate Cut Show that the Fed Knows More than the Market? | Lord Abbett
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Economic Insights

Some fresh thinking about the U.S. Federal Reserve’s economic forecasting firepower—and how it is perceived by the market.

On March 3, the U.S. Federal Reserve (Fed) cut the benchmark fed funds rate by 50 basis points (bps) in an “emergency” meeting. The market rallied at first—rate cuts are usually good for risk assets in that they loosen financial conditions—but then subsequently sold off by the end of trading on March 3. This reversal raises an interesting question: Does the Fed know more about the economy than markets, meaning if the U.S. central bank is worried enough to make an inter-meeting rate cut, that means things are really bad?

The answer is that the market reaction to monetary surprises is not consistent with this idea, according to previous research. However, in an age where the Fed’s unlimited budget and army of quantitative analysts can better harness new real-time data sources than most private teams of economists, maybe the Fed’s insights and expertise will have the edge over the rest of the financial sphere going forward. More importantly, the Fed’s reaction to potential changes in the outlook due to the coronavirus must be viewed in the light of its new operating doctrine: policymakers strongly believe that aggressive early action is necessary when benchmark rates are close to the “zero lower bound.”

How should we think about the Fed’s most recent action in this context? There are a few interesting points to consider. First, might the outcome of “emergency rate shifts” depend on the fundamental starting point? Bloomberg compiled a list of such events over the past few decades—only one of which is an “emergency rate” hike in 1994. Table 1 shows the return on the day of the rate announcement and the return one-week forward of the S&P 500® Index. As you can see, not all emergency rate moves are interpreted as bad and the subsequent weekly return may be better or worse than the one-day action. An emergency rate cut during the week of the September 11, 2001, terrorist attacks is clearly not about the Fed knowing more than everyone else, in our view, and the market had some catching up to do after a multi-day closure.

 

Table 1. What Has Happened to the Market after an “Emergency” Cut by the Fed?
Same-day and one-week returns on the S&P 500 Index following rate moves by the U.S. Federal Reserve on the indicated dates

Source: Bloomberg.
Note: The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is not a reliable indicator or guarantee of future results.

 

The Fed’s Outlook versus the Consensus View
Second, are the Fed’s forecasts better than the consensus views of economists? The traditional answer, based on a research paper from 20002 that looks at the 1980–1991 period, is that the Fed’s Greenbook3 is better at forecasting inflation than it is at predicting economic growth. But new analysis from the San Francisco Federal Reserve Bank looking at a longer time period (1980 to 2013) reveals that the Greenbook forecasts are not appreciably better than consensus.4 This casts doubt on the idea that the Fed has better information than the market. The authors of the new analysis also suggest some of the results in the older work may be driven by downward momentum in inflation resulting from the policy shock administered by Paul Volcker during his tenure as Fed chairman during the 1980s, which aimed to crack high inflation expectations with an upward jolt to interest rates.

Chart 1, adapted from the new San Francisco Fed paper, shows the relationship between consensus GDP forecast revision (measured from the Blue Chip Survey of economists) and the change in short-term interest rates in the 30-minute window around a monetary policy announcement, which is used to measure the strength of the policy surprise. The graph depicts a positive relationship between the strength of the policy surprise and the GDP revision. On the one hand, you could argue that the private sector sees the policy surprise, concludes the economy must be stronger than they previously thought, and increases their GDP estimate. On the other hand, you could also argue that the strengthening economy caused the Fed to raise interest rates and consensus to revise up their forecast, meaning news about the economy is driving the relationship in the graph. (One potential drawback to the methodology: The 30-minute window selected by the researchers may not fully register the market reaction the way a longer timeframe might.)

 

Chart 1. Blue Chip U.S. GDP Forecast Revisions and FOMC Monetary Policy Surprises
Data based on surprise monetary policy changes for the period January 1995–March 2014

Source: “The Fed's Response to Economic News Explains the ‘Fed Information Effect,’” Federal Reserve Bank of San Francisco Working Paper, February 2020.
The chart depicts the change in Blue Chip consensus forecast for real (inflation-adjusted) U.S. gross domestic product from one month to the next, plotted against the 30-minute change in short-term interest rates around FOMC announcements, from January 1995 to March 2014, excluding July 2008 to June 2009. Each circle represents an FOMC announcement; the eight solid circles denote the most influential observations in the relationship and are labeled with the month and year in which they occurred. Negative observations occurred when the economy was weakening and positive observations when the economy was strengthening.

 

The authors argue that the Fed is actually responding to news and that news about the economy is the missing variable in this vein of research.

The Law of Large Numbers (of Economists)
At this point, a third consideration comes to mind: Is it really possible that one economist can forecast better than the Fed’s army of economists? It’s a reasonable argument to say that one economist alone probably can’t compete with the entire professional staff of the Fed’s Board of Governors or its regional Reserve Banks. Indeed, I highly recommend reading all of the economic analysis put out by the reserve banks as it is usually unbiased and thoughtful. However, the Fed is probably subject to groupthink5 just like any organization. If that one solitary economist is taking a stand free from cognitive bias like groupthink, there is a case to be made that it is possible for one person to outperform the Fed. But we would expect these cases to be very rare. Thus, an emergency rate cut might represent the outcome of superior Fed information from this perspective.

However, the Fed is increasingly using alternative data that gives it a real-time picture of the economy.6 This approach was particularly useful during the U.S. government shutdown in 2018–19, for example. And the outbreak of coronavirus in early 2020 is in many ways the ideal time for alternative data: what we most need now is a timely measure of consumer behavior in response to this event. This is because the virus is unusually invasive in its impact on the activities of everyday people. If the Fed is using such data extensively right now they may in fact know more than the market.

Forceful, Aggressive Fed Policy
Last and most important, the emergency rate cut must be viewed in the light of the Fed’s new operating doctrine. One strand of research argues that monetary policy, both conventional and unconventional, should be deployed aggressively when policy rates are starting at already-low historical levels. Fed Governor Lael Brainard commented in a recent speech that “The delays often reflected concerns about the putative costs and risks of these policies, such as stoking high inflation and impairing market functioning. These costs and risks did not materialize or prove manageable, and I expect these tools to be deployed more forcefully and readily in the future.”7 The emergency rate cut on March 3 should be viewed in the context of early aggressive action.

Additionally, the Fed may also be seen as combating “the Most Dangerous Idea” described in a 2013 paper,8 that is, overly pessimistic beliefs about the efficacy of monetary policy. Just as central bankers can be too hubristic about their skills, society can fall victim to an unduly pessimistic view of what monetary policy can accomplish. In an era of excessive pessimism like today, we think central banking must be the art of the possible. Although they may not achieve the outcome they desire, in our opinion central banks must never lose confidence in the efficacy of their policy tools, lest they end up acting too passively as an economic crisis unfolds.

Financial advisors can hear the latest views of Lord Abbett experts on the current market by registering to hear a replay of our March 4 webinar, "Volatility: Challenges, Opportunities, and Helping Clients Stay Focused."

 

1Simon Kennedy, “A Brief History of the Federal Reserve’s Emergency Rate Shifts,” Bloomberg, March 3, 2020.

2Christina D. Romer and David H. Romer, “Federal Reserve Information and the Behavior of Interest Rates,” The American Economic Review, June 2000.

3The Greenbook of the Federal Reserve Board of Governors contains projections of various economic indicators for the economy of the United States produced by the Federal Reserve Board before each meeting of the Federal Open Market Committee.  

4Michael T. Bauer and Eric T. Swanson, “The Fed's Response to Economic News Explains the ‘Fed Information Effect,’” Federal Reserve Bank of San Francisco Working Paper, February 2020.

5The term groupthink was coined by Yale psychologist Irving Janis to explain how a group of intelligent people working together to solve a problem can sometimes arrive at the worst possible answer.

6Christopher Rugaber, “How’s the Economy? Fed Increasingly Turns to Private Data,” Associated Press, February 5. 2020.

7Governor Lael Brainard, “Monetary Policy Strategies and Tools When Inflation and Interest Rates Are Low,” 2020 U.S. Monetary Policy Forum, February 21, 2020.

8Romer and Romer, “The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter,” The American Economic Review, May 2013.

 

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basis point is 1/100 of a percentage point.

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Correlation is a statistical measure that describes the strength of relationship between two variables. It can vary from 1.0 to -1.0.

The Federal Funds Rate (fed funds rate) is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight.

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