The US Fed's rosy worldview rests on a misleading premise

Photo: Chip Somodevilla/Getty Images

The Federal Reserve’s credibility is increasingly under scrutiny as it insists on raising interest rates despite signs of continued weakness in the labour market and, importantly, an inflation rate that refuses to climb to the central bank’s official 2% target.

Fed officials often say their decisions about interest rates are data-dependent. However, this description has been tested lately by inflation figures that keep falling despite official assurances that downward pressures on growth and inflation seen during the first quarter would be “transitory.”

This has caused Deutsche Bank economist Torsten Sløk to redefine how he interprets the Fed’s notion of data-dependence. It looks a lot more like model-dependence.

“The Fed often says that their policy decisions are data dependent. Their data dependency is, however, very selective,” he said in a research note to clients. “Recently inflation has been moving down but the Federal Open Market Committee has nevertheless continued to raise rates and remain hawkish, with the argument that their models say that inflation will soon accelerate up to 2%.”

The problem is that the Fed’s optimism about growth and inflation has been misplaced before — rather often, in fact.

Indeed, wage growth and inflation itself have remained subdued despite a 4.3% unemployment rate, a sign that the job market still has some room to improve before returning to full health.

“Looking at speeches by the Fed chair over time there is indeed a pattern that [Janet Yellen] in recent years has been focusing more on ‘models’ than on ‘incoming data’ or ‘incoming information,'” writes Sløk.

“We agree with the Fed that inflation will move higher in coming quarters, but the fact that economists have been wrong in their forecasts of inflation for several years is a humbling experience both for the economics profession and for the Fed,” he cautions.

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