The Fed and the World’s Dumbest Smart People
Statist groupthink is keeping key inflation drivers alive and investment markets volatile.
Diversity by gender and ethnicity is at last ascendant at the US Federal Reserve, as it is for most institutions. Thinking behind policy, however, has rarely if ever been more in lockstep.
Only one current US Supreme Court Justice—Amy Coney Barrett of Notre Dame—did not attend either Harvard or Yale. The Ivies aren’t quite as dominant on the 12-member Federal Open Market Committee that votes on monetary policy. But like the lawyers on the Court, their educational background is broadly similar. And it’s centered on the idea that increased reliance on better data will always produce better answers to Economics questions.
I fully agree that more effective collection, processing and analysis of data can produce quantum advances. That’s what’s so exciting about artificial intelligence, which puts the power of advanced computing to work. Electric utilities, for example, are benefitting from rapidly expanding demand, but also the ability to vastly improve their management of increasingly complex systems.
Economics, however, is a study of human behavior. Professors at elite universities teach students to parse units of production and profit in as many ways as do Engineering, Chemistry and Physics. And their ability to do so has been greatly augmented by advances in data science.
Yet, there’s never been an algorithm devised that consistently and accurately forecasts economic growth, inflation and especially stock market returns. That’s not for lack of trying, or resources thrown at the problem. But at the end of the day, the global economy is 8 billion plus human beings making millions of decisions they frequently reverse, and for just as many reasons.
The result is the unexpected is the rule. And the best economist/navigators are always those who can think on their feet, combining experience with the data to produce the best outcomes.
Sadly, those aren’t the skills that enable people to rise to the top of giant, increasingly statist institutions, including those that have a massive impact on the economy and especially investment markets. And Exhibit A is the current almost purely reactive thinking on the Fed.
Earlier this month, Consumer and Producer Price Inflation for January clocked in slightly above what had been the consensus expectation of many economists. The annualized rate of roughly 3 percent for both wasn’t really much out of trend with previous months. And it should be pointed out that like almost all data reported by the US government, CPI and PPI are based on surveys rather than a hard count, which makes them subject to wild revisions.
But if you’ve listened to comments of various FOMC members and Fed governors, it’s clear in their eyes that the world shifted. The San Francisco Fed President probably summed up the “sentiment” best with the statement “we will need to resist the temptation to act quickly when patience is needed and be prepared to respond agilely as the economy evolves.” She went on to say “Ongoing economic momentum that outstrips available supply remains a risk to the inflation outlook,” but then qualified by implying a danger the “labor market” could “pivot” suddenly lower.
Takeaway one from that is a reluctance to say anything definitive. But it’s also clear from this and other comments that this central bank is essentially just watching the markets. There’s little or no real conviction about the trend. And the “solution” for the foreseeable future will be to watch and react to the “data.”
To be fair, Fed governors have always had a difficult job. FOMC voters are generally well off enough to be insulated personally from the consequences of getting things really wrong. But holding the cost of borrowing too high or even too low for too long can be catastrophic not just for Americans but around the world.
At the bottom line, the Fed influences one thing. That’s the cost of borrowing, especially on the short end where benchmark interest rates most closely follow its actions. On the longer end, rates tend more to follow inflation expectations.
Borrowing costs are one of multiple factors affecting the level of consumer spending, which drives economic growth. But they actually have a far greater impact on investment, and this period of “higher for longer” interest rates has demonstrably reduced business’ appetite for it in multiple industries including energy and housing.
Ironically, there’s been a consensus of economists the past couple years that new housing stock coming on the market would drive down rents if not prices—becoming a significant deflationary factor. But it’s been a far different story on the ground.
This past week, I reviewed Q4 results and guidance in my advisory The REIT Sheet for a number of major real estate investment trusts specializing in residential property. And not only are rents still rising around the country. But management is no longer concerned about new supply depressing earnings in 2024. In fact, guidance is now for a profit re-acceleration starting later this year—the result of higher borrowing costs that have depressed new development.
In other words, by following an Economics textbook prescription for reducing inflation—influencing borrowing costs to be higher for longer—the Fed is creating the conditions for higher long-term inflation in housing right before our eyes.
It’s doing the same for food and energy as well. Conventional wisdom is prices of both are “too volatile” to give an accurate reading of inflation. But it’s clear from the accelerating North American shale oil and gas mergers—last week Diamondback Energy (NSDQ: FANG) bid for privately held Endeavor Energy Resources LP—that energy companies are interested in building scale rather than far riskier new exploration. And despite record US oil and gas production last year, investment in new supply is lagging long-term underlying demand more than ever.
So what does this mean for investors? First, be prepared for some wild stock and even bond market volatility this year. Big investors are fully aware this is a reactive Fed. And that means any announcement perceived as holding a clue to central bank actions can trigger truly massive near-term buying and selling momentum in stocks.
Second, expect future inflation and prepare for it by adjusting your portfolio. Energy, property and electric utility stocks are three solid, out of favor and high yielding sectors where bargains currently abound. And their stocks are still likely to get a big boost later this year, if and when the Fed does react to the “data” by cutting interest rates.