Why the Fed is blowing it
Incorrect priorities lead to incorrect conclusions
I have been offering piecemeal rankings week by week of the topical indicators of the week, ranking them in their recent historic context. My conclusion has consistently been that economic variables are far too weak to justify Fed policy. I have weekly calculations (performed on ranked growth rates going back to 2010) for data since late October of last year that produce this same result/conclusion week by week without fail. And yet the Fed hiked rates in December and it continues to assert that its program of rate hikes is still on path even though that path might take a lower gradient. What gives?
In the table above I have finally taken the full approach by ranking a broad set of 50 variables instead of just taking whatever was offered up new, week-by-week. Again I rank variables on their growth rates or levels since January of 2010 to date and I have sorted them into groups and averaged their standings to create readings on different measures. These group rankings are revealing. And not surprisingly they give substance to a criticism I have been levying at the Fed for some time. But here we have data to support it and context for the Fed’s missteps.
The Fed has a labor market centric view of the world. And, while the world outside the labor market is unraveling, the labor variables have remained relatively strong. This means that the Fed, with its blinders on, views what appears as a strong economy (through the lens of that strong labor market). However, when we look at other variables what we observe is a much weaker U.S. economy and one that would hardly support the policy that the Fed chose to pursue in December and is still pursing.
The table above shows that the labor market variables over about the last 70 months have an average ranking in the top 5% of their queue of data since January 2010. No wonder the Fed sees a strong economy. However, the next strongest sector is housing which has only a 53 percentile standing. After that it is services with a 43 percentile standing. After services the consumer sector has a 33 percentile standing. After the consumer sector price trends have a 26 percentile standing. After price indicators, the general economy, including trade, has a 16 percentile standing. With a 9 percentile standing, the factory sector comes in as the weakest of all. There is no surprise there.
So the factory sector has been weaker only 9% of the time since January of 2010. And only two of these seven categories have rankings that push them above their medians in what has been a disappointing economic recovery. And the strongest of these categories is - SURPRISE - the one the Fed has chosen to target for its policy focus, the labor market. It’s as though there is some bizarre form of Goodhart’s law at work. The Fed chooses to target the labor market and the labor market stops being representative of the economy.
The Fed decision to make the labor market primary in its analysis of the economy is why policy is running amok. In the last FOMC minutes the Fed even included language defending the use of the labor market as a focus over and above GDP figures (GDP is not used in the table above since I have only used indicators with a monthly frequency).
The Fed has set up a straw man choice (labor vs GDP) to justify the use of labor data (GDP is too often revised). But, focusing on the labor market is not the best forward looking indicator-and there are many other choices. We do not have to accept the Fed’s strawman. Right now, for example, the growth in the index of leading economic indicators leaves it ranking in the 39th percentile of its historic queue of growth rates back to 1969. The coincident index sits in its 34th percentile. Needless to say, the LEI’s strength is not very comforting. Of course, it has slowed like this before without signaling recession. But this is a significant slowing and it is occurring with the Fed’s gas pedal still nearly to the floor… and the Fed has few options to do more should the economy sour. Since the Fed has no latitude to help should things continue to slide, that limitation should be part of the policy decision.
As I have said before, this the most disturbing thing about Fed policy. It is not that I think that Fed policy is wrong. It is that, objectively, the Fed’s policy course is dangerous since it assumes that the economy will not backslide in an environment where everything already is backsliding except the ONE INDICATOR that the Fed has chosen to focus upon (the job market). If the Fed has chosen badly in terms of its focus or in terms of its forecast there is no fallback position for policy. And several Fed members are quite dogmatically attuned to keeping rates moving up because they are convinced that they must make up for past sins and that inflation is gaining on them. This is the view that (1) rates were too low for too long, or that (2) the Fed balance sheet is just too big or (3) that the unemployment rate is just too low. This spectrum of ‘just-toos’ brings Monetarist and Keynesians together in a love fest of agreement and gnashing of teeth over inflation risks and so obseesed with teh past that they cannot see what is happening or appreciate that the future might different from what they obsess over. That’s why they call it an obsession.
Meanwhile incoming data make a different point altogether.
The table at the top shows that economic data have been weak- almost everything outside of jobs data has been weak. What are the odds that the jobs data will lead us out of the wilderness while everything else remains weak or gets weaker? Probably not very good... This is where I start calling the Fed dogmatic and accuse it of not really being data-dependent, as it claims it is, unless data dependency means that it depends on what data they want to look at. Oh. Now I get it.
Data classification used for these calculations is