The Fed Cuts Again. But Can It See Through the Data Fog?

They did it again. Fed head Jerome Powell and his trusty cabal cut the fed-funds target range by  0.25 percentage point (ppt), bringing it to 3.75% - 4.00%. They also announced they will stop shrinking the Fed’s balance sheet on December 1, ending “quantitative tightening” (QT). But most attention is already turning to December and whether the Fed will cut again, with Powell pushing back on efforts to predict policy moves even harder than usual. That seemed to feed fears that the Fed could be on the verge of a policy error, especially with policymakers lacking fresh government-produced economic data to guide them. To us, it all misses a simple point investors would benefit from keeping in mind: Policy error is always a risk, no matter how much data the Fed has.

Higher perceived error risk stems from a few factors. One, the Federal Open Market Committee continues dissenting on rate decisions, with one dissenter pushing for steeper rate cuts to boost the economy and employment and one pushing to hold due to inflation’s uptick. Powell noted this tension in his presser, alluding to stronger dissent and divisions behind the scenes, noting this made December’s move even more of a wildcard than usual. (We have a fun mental picture of the two dissenters arm-wrestling to a draw.) He also said that with the job market softening as inflation ticked up, “there is no risk-free path for policy as we navigate this tension between our employment and inflation goals.”^[i] Now, we don’t think there is ever a risk-free policy path. Risk-free doesn’t exist. But commentators jumped on it all the same.

Two, the lack of official economic data, which Powell likened to driving in fog. What do you do when thick fog impairs visibility? “You slow down.” He added, a “very high level of uncertainty, that could be an argument in favor of caution about moving.” Yet when asked about the risk of flying blind, he also downplayed it, noting the Fed still gets some inflation and jobs data and that it will produce the Beige Book again. That boringly named tome is the Fed’s in-house economic assessment, based on available data and all the information regional Federal Reserve Banks get from business contacts in their district. “We’re not going to be able to have the detailed feel of things, but I think if there were a significant or material change in the economy one way or another, I think we’d pick that up.”^[ii]

This seems like Powell’s attempt to downplay fears that driving in fog raises the risk of a major accident, to extend his earlier metaphor. And look, we think he is right to point out that the Fed isn’t flying blind. But also, even with all the data at its disposal, the Fed’s record of identifying “significant or material change” is also pretty bad. In the past, they have not “picked that up.”

How do we know? Simple: The Fed releases transcripts of every meeting, at a five-year delay. So we know that in January 2008, as the US economy was entering a recession, Fed members still forecast positive full-year economic growth. That June, we know the Fed paused its rate cuts because economic data were surprising to the upside and policymakers were raising their growth forecasts. One noted her recession fears were easing. In reality, the recession was already underway, worsening and had another year to run. We think it is fair to say the longest recession in recent memory was a “significant or material change” in economic conditions, and the Fed didn’t correctly identify it until far too late.

This speaks to two points of weakness. One, simple human error. Two, so-called gold-standard economic data aren’t perfect. One reason Fed people continued downplaying recession risk is that the recession didn’t become apparent in headline data until late in the year, after several rounds of GDP revisions. They also relied heavily on consumer spending to guide them, given it is the majority of GDP, but it wasn’t the swing factor. Business investment was, as usual, and it was kind of a Fed blind spot. Imperfect people using imperfect data make imperfect policy.

We saw this in 2022, too. We won’t have transcripts for a few more years, but we know from Powell and others’ public statements that they didn’t foresee inflation running as hot as it did, leading them to delay rate hikes and talk down the likelihood of acting. Once they conceded to CPI’s fast rise, they U-turned quickly, hiking much more and more swiftly than anyone expected. That didn’t cause a recession, even though it eventually inverted the yield curve, but the quick about-face spooked investors, adding to the fears that caused 2022’s shallow bear market.

So no, we don’t think the Fed is likely to spot a “significant or material change” in advance or in real time, shutdown or no shutdown. As a result, potential monetary policy error is always a risk to weigh. No matter who heads the Fed, no matter how much data they have, no matter what the current economic landscape looks like. To continue Powell’s driving metaphor, you wouldn’t drive by exclusively peering through the rearview mirror. But all economic data look backward. Maybe that explains the lack of picking up twists and turns in time?

This is a big reason we say trying to predict the Fed is pointless. It isn’t just because the Fed is unpredictable, as this whole December kerfuffle highlights. It is also because every decision, whether or not it matches expectations, carries the risk of error, and investors need to weigh those risks. The only way to do this is to judge the decisions after the fact. You can’t judge a question mark.

As for the present, we don’t think the Fed is making mistakes now. We don’t think the US economy needs rate cuts, as things look mostly ok, but all else equal, they promote a steeper yield curve. The US curve is flatter than its overseas counterparts, partly because the Bank of England and ECB cut more swiftly, so there is some room to catch up. Ending quantitative tightening shouldn’t cut against that, as the Fed’s shrinking bond holdings weren’t a huge factor in the market. Plus, Powell alluded to focusing its reinvestment on shorter-term Treasurys, which would mean less Fed pressure on long rates than there might otherwise be. But ultimately, we think global bond supply and demand fundamentals will be a bigger force.