The Fed And Goldilocks Economic Forecasting

June 22nd, 2012

by Lance Roberts

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Beginning in 2011 the Federal Reserve begin releasing its economic forecast for the present year and two years forward, covering GDP, Unemployment, and Inflation. The question is, after 18 months of these forecasts, just how accurate has the Fed been in forecasting these economic variables? I have compiled the data from each of the releases for each category, comparing them to the real figures, and using a current trend analysis for future estimates.

GDP

When it comes to the economy the Fed has consistently overstated economic strength. Take a look at the chart and table. In January of 2011 the Fed was predicting GDP growth for 2011 at 3.7%. Actual real GDP (inflation adjusted) was 1.6%, or a negative 56% difference. The estimate at that time for 2012 was almost 4% versus 1.8% currently.

We have been stating repeatedly over the last 2 years that we are in for a low-growth economy due to the debt deleveraging, deficits and continued fiscal and monetary policies that are retardants for economic prosperity. The simple fact is that when an economy requires nearly $5 of debt to provide $1 of economic growth, the engine of prosperity is broken.

As of the latest Fed meeting, the forecast for 2013 and 2014 economic growth has been revised down as the realization of a slow-growth economy has been recognized. However, the current annualized trend of GDP suggests growth rates in the next two years that will roughly be half of the Fed's current estimates of 2.85 and 3.4%. A recession in 2013 is a strong likelihood given the current annualized trend of economic growth since 2000. A recession followed by a rebound in 2014 would leave economic growth running at annual rate close to 1% to 1.5% range versus the current estimate of nearly 3%.

What is very important is the long run outlook of 2.6% economic growth. That rate of growth is sub-par and, over the longer term, does not sustain the level of incomes and employment that were enjoyed in previous decades.

Unemployment

The Fed is as overly optimistic about the level of unemployment as they are about economic growth. One of the Fed's mandates is "full employment." At the beginning of 2011 the Fed predicted the unemployment rate for the year would be 8.7% for 2011, 7.8% for 2012 and 6.95% for 2013. The unemployment rate for 2011 was 9.1% and is currently at 8.2% and likely to rise in the coming months as the economy again weakens.

The Fed sees 2014 unemployment falling to 7% and ultimately returning to a 5.6% "full employment" rate in the long run. The issue with this full employment prediction really becomes what the definition of reality is.

Today, the average American has begun to question the credibility of the BLS employment reports. Recently even Congress has launched an inquiry into the data collection and analysis methods used to determine employment reports. Since the end of the last recession, employment has improved modestly but mostly because of growth in temporary and lower paying positions.

Since mid-2011 there has been a fairly sharp decline in the unemployment rate from 9.1% to the current 8.2%. The main driver of that decline has come from a shrinkage of the labor pool versus substantial increases in employment. In our past employment reports we have discussed the increasing number of individuals who are moving into the "Not In Labor Force" category, the result being that they are no longer counted as part of the labor pool. For the Fed, the reality of "full employment" and statistical "full employment" are two entirely different things. While the Fed could be correct at achieving a "full employment" rate of 5.6%, in their longer run scenario it certainly doesn't mean that 94.4% of working age Americans will be gainfully employed.

Inflation

When it comes to inflation, the Fed's outlook, for the most part, have been below reality. In January of 2011 The Fed's prediction for 2011 inflation was 1.5%, which was 2% lower than what inflation turned out to be.

As of the latest meeting, the Fed's 2012 inflation prediction is 1.6%. With current deflationary pressures pulling headline inflation down from 3% at the beginning of this year to the latest reading of 1.7%, the Fed's prediction appears to be fairly accurate. The question, however, is how long can inflation remain suppressed at or below 2%, which is the long run prediction of the Fed?

The Fed has much more control over inflationary pressures in the economy than they do at stimulating economic growth or increasing employment. By increasing or decreasing interest rates, using monetary policy tools and coordinated actions, the Fed has historically been able to influence inflation. Unfortunately, their actions in this regard can also be directly linked to economic and market booms and busts.

What the Fed has much less control over are deflationary pressures. We have discussed that the threat of deflation in the U.S. economy is currently much greater than the inflationary risk. It is also the primary concern of the Fed. However, there are two things that are likely occur that could drive headline inflation higher than the Fed's current long run estimate of 2%. The first is further stimulative action that expands the Fed's balance sheet, commonly referred to as "quantitative easing." The direct impact of these programs, as liquidity is injected into the financial system, has been higher commodity prices, which translates to an increase in headline inflation.

The second, and more importantly, is that an organic economic recovery will eventually take hold. During real economic expansions, when demand is increasing, wages are rising and the velocity of money is accelerating, real levels of higher inflation take hold. However, an organic economic expansion is likely some years away as the balance sheet deleveraging cycle continues globally.

Why The Fed Forecasts Like Goldilocks

Is the Federal Reserve really as bad at predicting future economic conditions as it appears? The answer is no. The Federal Reserve faces a severe challenge, when communicating to the financial markets and the media, which is the creation of a self-fulfilling prophecy. Imagine that following an FOMC meeting Bernanke stated: "The policies and actions that we have implemented to date have done little to curb economic weakness. The economy is in much worse shape that we have previously communicated as the transmission system of Fed policy through the economy, and the financial markets, is obviously broken."

The immediate reaction to such a statement would be a complete collapse of the financial markets. Such a collapse would devastate consumer confidence, which would subsequently throw the economy into a massive recession. Conversely, an overly optimistic outlook would lead to an increase of inflationary pressures and asset bubbles. Neither situation is healthy for the economy in the longer term. Therefore, communication from the Federal Reserve must be very guided in its approach - not too hot or cold. This "goldilocks" approach works to create a "glide path" to the Fed's destination while giving the financial markets and economy time to adjust to the incremental adjustments to forecasts.

Let me be clear. I am not making a case for the relevance of the Federal Reserve or its policies. That is another article entirely. What I am stating is that the communications from the Federal Reserve should NEVER be taken at face value. Since the Fed cannot communicate its real position at any given time, due to the immediately excessive positive or negative effect on the economy and financial markets, we as investors must read between the lines. The problem for the financial markets, and the mainstream media, is that they tend to extrapolate current estimates indefinitely and generally in an upwardly biased manner. This is not the Fed's objective nor have they been able to repeal the economic and business cycles.

The Fed has been slowly guiding economic forecasts lower since 2011. The reality is that 2.6% economic growth is not a boon of economic prosperity, corporate profitability, increasing incomes or a secular bull market. It is also not the "death of America" or the return to the Stone Age. What is important to understand, as investors, is the impact on investment portfolios, expected real rates of returns and the realization that higher levels of market volatility with more frequent "booms and busts" are here to stay.


Originally posted at Lance's blog: streettalklive

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