Federal Reserve and ‘idiot’ economists risk recession in US

Economists are idiots and the Fed is worse for giving too much weight to their views on inflation, according to Yarra Capital Management’s Tim Toohey.

Economists are idiots and the Fed is worse for giving too much weight to their views on inflation.

That’s the provocative view of Yarra Capital Management’s head of macro strategy Tim Toohey, who once served as chief economist at Goldman Sachs Australia.

After failing to detect the inflation shock of the past two years in advance, economists and central banks haven’t acknowledged that the source of the inflation shock has rapidly reversed.

Commodity prices have dropped sharply and freight rates are back near long-run averages.

US supply chain blockages have been cleared, “nowcasts” show three-quarters of stall-speed domestic demand and leading indicators suggest greater growth challenges lie ahead.

While the Fed has finally noted that excessive inventories will likely result in a bout of discounting in coming quarters, Toohey says it’s “not clear that they remotely understand just how disinflationary this process will become in a flat demand environment”.

But the kicker is that global monetary policy, led by the Fed, has arguably never been more influenced by the collective outlooks of private sector forecasters than it is now.

In late 2020, the Fed quietly decided to calibrate its monetary policy to a new model of long-run inflation called the “index of common inflation expectations”.

When it was first published in September 2020, the Fed’s CIE index had plumbed a record low of 1.94 per cent at the start of the Covid-19 pandemic in the March quarter. But by mid-2022 it hit a record high of 2.33 per cent, led by long-term inflation expectations.

In November 2020 and January 2021, Fed vice-chairman Richard Clarida said he “follows closely the staff’s index of common inflation expectations as a relevant indicator that this goal is being met”.

Clarida’s “desired pace of policy normalisation post lift-off to return inflation to 2 per cent – as well as the projected pace of return to 2 per cent inflation – would be somewhat slower than otherwise if the CIE index is, at time of lift-off, below the pre-ELB (effective lower bound) level”.

“This is another element of why the Fed got it wrong – they were deliberately waiting for an overshoot in inflation expectations before reacting,” Toohey said.

While the common inflation expectations model has more than 20 inputs, Toohey argues that it gives “excessive weight to the forecasts of professional economists”.

In June this year – after delivering the first of four massive 75 basis point hikes in the fed funds rate – Fed chairman Jerome Powell said the CIE “has moved up after being pretty flat for a long time, so we’re watching that, and we’re thinking, ‘this is something we need to take seriously’.”

The Fed’s CIE estimate slipped to 2.3 per cent in the September quarter. The Fed’s inflation target is 2 per cent.

Toohey has no doubt expectations of a continued rise in the CIE helped reinforce the hawkish rhetoric that has come from all Fed officials in recent weeks.

“The idea here is that the Fed is still so worried by the rise in inflation expectations becoming embedded that they will commit to an ongoing series of rate rises in coming months,” he said.

His monthly version of the Fed’s CIE model shows most inputs are still well above the index.

At first glance, the risks to long-run inflation expectations are skewed higher in coming months. But after categorising the inputs, he says consumer and financial market average expectations have already commenced a significant decline in long-run inflation expectations.

So why hasn’t the common inflation expectation index clearly peaked? For a start, the Fed model is only published quarterly. But it also gives more weight to the survey of professional forecasters.

“The objective of the financial market economist is to formulate a view of how the world will evolve, communicate and defend that view – even if some of the incoming data is challenging that view – until the evidence is so overwhelming that they move to a different view of the world,” Toohey said.

In his view, financial markets and consumers are more alert to easing inflationary pressures.

“If economists are indeed relative idiots when it comes to forecasting inflation, then in gauging the all-important direction of inflation expectations, the Fed’s decision to ascribe more weight to the forecasts of professional economists makes the FOMC worse,” he said.