More Disconnect

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The latest meeting of the Federal Reserve Bank’s Open Market Committee (FOMC) — which determines the monetary policy of the United States and fixes short-term interest rates — ended on Wednesday afternoon (EST). The decisions announced were exactly in line with what had been expected — primarily, another reduction in the Fed’s program of bond-buying, in line with a process that began late last year. Nevertheless, financial markets were very pleased with the outcome: prices of stocks and bonds rose, first in the US and subsequently in most global markets.

The presumed explanation for this positive reaction was that the Fed might have made moves towards tightening monetary policy, or even noted that such a possibility had been discussed — but it did not. With the option of even looser monetary policy in the US currently not “on the table”, no worse is considered good. That makes sense, especially in the post-crisis “New Normal” world where the actions and statements of the world’s leading central banks are the key movers of financial markets, whilst mere economic fundamentals have been rendered unimportant.

Nevertheless, the FOMC meeting was accompanied by some important background material, notably a periodic update of the Fed staff’s forecasts for economic growth, inflation, unemployment and the latest assessment of FOMC members as to where interest rates will be in one and two years time. This last item, termed “counting the dots”, because of the way the assessments are portrayed on a graph, has become very popular among analysts in recent months, as a way of gauging which way the wind is blowing among Fed governors in terms of beginning the process of raising interest rates from their near-zero levels.

The latest update contained several important insights. First and foremost, the Fed sharply cut its forecast for economic growth in the US this year, from a range of 2.8-3.0% previously, to a range of only 2.1-2.3%. Other changes in the Fed forecasts, to inflation and unemployment rates, were marginal — slightly higher on inflation, slightly lower on unemployment. But the outlook for growth was sharply lower — and this in the wake of updated forecasts from the IMF, which also cut its expected rate of GDP growth in the US and globally.

It cannot be emphasized too strongly, for the benefit of readers who are not economists and don’t deal with this kind of stuff in their professional capacities, that all these forecasts are devoid of any substantive value, because the record of the forecasters — especially, but not only, the governmental ones — is so appallingly bad. This has been exhaustively proven over the years by formal research, but there is a simple reason why they can’t get it right and that is because they don’t want to. Their job is not to be accurate but to be part of the make-believe world in which things are
improving or actually good. Either way, they will be better still later this year, next year and the year after. Declines, let alone recessions, have become unacceptable in the world of professional forecasting.

That explains why the Fed’s forecast for 2014 is going the same way as its predecessors, namely downhill. The Fed began forecasting 2014 at the end of 2011, when the range of expected GDP growth was 3.4-4.0%. This would have come, in the Fed’s dream world, after higher growth in 2012, better in 2013 and stronger yet in 2014. Unfortunately, despite the trillions of dollars that the Fed has pumped into the economy over these years, growth has consistently disappointed, so that the forecasts for 2012 and 2013 were gradually reduced, as reality intruded inexorably. The forecast for 2014 was dragged lower in this process, which is how the Fed got to its 2.8-3.0% forecast in March this year — having reduced the upper end of the range by a full percentage point over the previous 15 months. Now, three months later, both the upper and lower points have been slashed by a massive 0.7% in one shot.

The financial markets paid no attention to this because, as noted, the only thing that matters to them anymore is whether the flow of near-free money from the Fed and other central banks will continue. Economic fundamentals are no longer relevant to the markets, only to mere people, the bottom 99.9%. This is true both regarding macro-economic fundamentals — slower growth, higher inflation, wider current account deficit, falling house sales are the most prominent of this week’s news items in this context — or at the level of individual companies. The fact that profits — even the make-believe, non-GAAP financial statements that most American companies publish and promote — are eroding whilst stock prices rise, so that valuations are at historically high levels, doesn’t make any difference in a zombie market that runs on government-provided liquidity.

The mantra that the liquidity junkies chant endlessly is that “you can’t fight the Fed”, the corollary of which is that the prices of equities and bonds can only rise. That explains why hedge funds, which have as a class performed appallingly, are now more committed than ever to the equity markets, with cash at record lows. The herd is all in and more optimistic than ever — with ever less basis.