December 21, 2021

The new operating procedure put a stake in the heart of the passive operating procedures of the Volker price rule and culminates the transition from a passive monetary policy to a proactive monetary policy. The lynchpin of the new procedures is the so called forward guidance. It is nothing more than a forecast of future economic conditions upon which the Fed makes its decision as to how to adjust its monetary policy to offset any undesired monetary disturbance that the forecast anticipates. The success of the new operating procedures will depend critically on the accuracy of the Fed’s forecast. Yet as we know the Fed’s track record is not all that. Let us just review some of the most memorable misses. The first one we have in mind is Sir Alan Y2K forecast. The Fed expanded its balance sheet and when nothing happened as 2000 came and went. The Fed quickly withdrew the excess cash it had provided. In the after math the US inflation rates increased above the target range and the economy experienced a shallow recession. The Bernanke Fed was quick to react to the Financial Crisis and provided the liquidity that avoided a full-fledged recession deflationary spiral. But clearly it did not anticipate the crisis otherwise it would have taken a preventive action. To accommodate the expansive fiscal policy through its bond purchases, the Fed had to enact the financial repression to prevent the balance sheet expansion from fueling the inflation rate. We contend that because of the overly optimistic real GDP forecast, the Fed enacted a too restrictive financial repression and that led to an inflation rate consistently below the 2% target rate, Figure 1. The Powell Fed fared worst. In addition to delivering a less than 2% PCE inflation, in 2019 as the recovery was accelerating, true to form, the Fed chose to raise interest rates. Mr. Powell caught the wrath of President Trump, who argued that the Fed was making a mistake. Rumor had it that President Trump was looking to fire him. Jerome Powell did not budge, and the press celebrated his stance and lauded the Fed independence. But looking back, was that an act of independence or stubbornness? Due to the wrong forecast, within a few months the fed had to reverse itself. Another miss has to do with the Pandemic recovery. The Fed underestimated the strength of the recovery and as a result implemented a looser financial repression. The net effect being a surge in the inflation rate well above the 2% target rate. Going forward the according to the latest FMOC bulletin, the Fed is forecasting a deceleration of economic growth into a 1.8% “long term” real GDP growth rate. A new new normal? Given the Fed recent track record, the Fed forecast, or forward guidance makes us wonder what is more likely, that the Fed will overestimate or underestimate the real GDP growth rate? We believe that as the economy approaches it long run growth rate, the Fed will overestimate the real GDP growth and that will lead to an excessive financial repression. Over the near term we expect the inflation rate to decline faster than the Fed forecast. The long-term downside is that the new operating procedures have too many moving parts and no discipline to force the Fed into acting quickly. As we already mentioned if the forward guidance forecast proves accurate, the Fed will avoid the costs associated with the monetary disturbances. However, if it misses the forecast, the policies enacted have the potential to make matters worse. That is the potential weakness of the new monetary procedures, the Fed forecasting record. We even Jerome Powell seems to have acknowledged in the record is not particularly great. Welcome to the Powell roller coaster.

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