It's official: the glass is (almost) always half empty for the Fed

Well, the Fed minutes were generally just as dovish as you might have expected given Yellen's press conference and her subsequent speech last week.  Macro Man had to laugh at the one bit where the committee

"agreed that their ongoing assessments of the data and the implications for the outlook, rather than calendar dates, would determine the timing and pace of future adjustments to the stance of monetary policy." 

Just a couple of sentences later,

"several expressed the view that a cautious approach to raising rates would be prudent or noted their concern that raising the target range as soon as April would signal a sense of urgency they did not think appropriate."  

Funny, Macro Man could not find "April" listed amongst the data releases on FRED, though strangely enough he did find it on his calendar.  Anyhow, so much for "every meeting being live", assuming the passage above quotes Yellen and her coterie of doves.

Macro Man has never paid much attention to the "balance of risk" tables in the minutes, but after yesterday's release he went back and tabulated the FOMC's balance of risk estimates since they were first released in 2011.   The calculation method is simple:  respondents suggesting risks to the upside less respondents suggesting risks to the downside equals net balance of risk.  The results, meanwhile, were remarkable if not totally surprising:   The FOMC is an institution for whom the glass is always half empty, the sun is always in shadow, and the postman never rings once, let alone twice.

The pessimism is perhaps most understandable when it comes to GDP forecasting, as growth outcomes have generally undershot the Fed's forecasts as the FOMC has slowly come to grips with the decline in trend growth.  (The median estimate for long-run GDP growth has fallen from 2.65% in 2011 to 2.0% now.)  Still, even though growth has generally undershot the Fed's forecasts, it's still notable that not once over the past five years has the FOMC ever thought GDP risks were not tilted to the downside.

The data on unemployment is even more remarkable.   Anyone who's followed the labour market and the Fed's forecasts for the past five years knows that a) the unemployment rate has fallen sharply in more or less a straight line, and b) the Fed has persistently underestimated the degree of the decline in the unemployment rate.   Yes, there have been mitigating circumstances via the decline in participation, but the Fed's forecasting track record has nevertheless been execrable, comfortably under-performing a simple linear extrapolation ever since the SEP forecasts have been published.  This makes it all the more remarkable, therefore, that not only have the Fed's unemployment rate forecasts been too high, but they've almost always thought that the risks to those forecasts have been tilted to the upside!  In fact, in the three years from June 2011 to June 2014, there were only two instances in which even a single member of the FOMC thought that the unemployment rate risks might be tilted to the downside.

Finally, we come to the core inflation risks, which these days are probably the most important.  It's easy to forget that a few years ago the core PCE deflator actually printed above 2%, though of course at that point the Fed didn't give a hoot because there was too much slack in the labour market.  Back in the early days of the SEP, however, the committee did deem the risks as tilted to the upside for inflation.  From mid-2012 onwards, however, the risks were justfiably deemed to the downside as core PCE inflation undershot both the committee's forecasts and its 2% inflation target.  Since the middle of last year, however, something remarkable has happened.   Not only has core PCE turned higher, printing at a level above the FOMC's implicit 1 year forecast for the first time in nearly four years, but the committee's assessment of the risks to their forecasts have also turned the most bearish ever.  Despite the recent upside surprises to core inflation prints, not a single FOMC member has deemed the risks as tilted to the upside in the last two forecast rounds.

An obvious catalyst for this apparent wedge between the performance of inflation and the Fed's assessment of risks is of course overseas developments.   This was clearly highlighted in both the minutes and in Yellen's recent communications; as Macro Man observed last week. the Fed has joined large swathes of American manufacturers in outsourcing its mandate to China.

An interesting question is how long will the wedge between the Fed's pessimism and data suggesting mandate-consistent conditions endure before the Fed is forced to capitulate in its view?  To be sure, recent trade data will have done little to assuage the Fed's concerns, but if employment and inflation data continue to hold up, will the Fed blink at some juncture?

If it endures long enough, then yes.   Back in the good old days (cough, cough) one might have expected the bond market wolves to pounce on any perceived policy error by selling bonds and steepening the curve.  Alas, the feral bond market vigilantes have been hunted to the brink of extinction, replaced by docile lapdogs who salivate whenever the white-coated Fed PhDs ring the bell for another course of easy money.  

And ring the bell they will, if the last few weeks is any indication.  Macro Man had a play with his Taylor Rule model and has come up with a set-up that has mapped the Fed's reaction function pretty well.  It certainly seems as if Yellen has opted for the "optimal control" policy framework after all, as recent communication clearly suggests a Fed content to remain lower for longer, even if it means raising more aggressively should inflation surprise to the upside.  (Ed.'s note: isn't that what it's been doing?)

In any event, by changing the pre-crisis settings to allow for a lower natural interest rate (1.5% from 2.0%), a much lower NAIRU (4.5% from 5.5%), and a higher inflation target (2.5% from 2.0%), we can see the QE period, the taper, and then eventually (and gradually) an argument for a slight rate rise...which is where we are now.

Should the Fed's median forecasts for growth and inflation eventuate, it would argue for another 1-2 rate hikes by the end of this year....exactly what the power brokers are looking for (and what the market is pricing.)

In a way, Macro Man feels like the scales have fallen from his eyes, and considers himself a fool for not looking into this balance of risk stuff earlier.  Yes, we know the Fed is a risk manager and yes, we know that many of them are academics wedded to imperfect models.     But until performing this analysis he wasn't quite sensitive enough to the committee's willingness and ability to suspend reality to always focus on the downside of life.

Henceforth, Macro Man has a plan to get himself into the Fed's mindset that he can recommend to any readers who struggle to appreciate how downbeat the FOMC can be:

1) Take your worldview
2) Imagine that you've been transported to a run-down corner of central Detroit
3) It's February
4) The wind is howling, the sky is black, and a bone-chilling sleet is driving down
5) You are standing chest high in raw sewage
6) And you've just dropped your car keys

Good luck!