Wednesday, November 6, 2013

It's The Economy Stupid: Jupiter aligns with Mars, then peace will guide the planets

Another warm and fuzzy piece on the Fed capability.

My takeaway: "Long equity capital and long real estate positions should do just fine in either case."

-----Original Message-----
From: David Zervos
Sent: Wednesday, November 06, 2013 10:02 AM
To: John Broussard
Subject: Jupiter aligns with Mars, then peace will guide the planets

"The function of economic forecasting is to make astrology look respectable."
– John Kenneth Galbraith

Just about 23 years ago I entered the Marriner S. Eccles building for the first time, walking through the doors on C Street between 20th and 21st. As I passed security and stood in the foyer, I marveled at the beautiful paintings lining the walls on loan from the Smithsonian Institution. I then looked up at the ornate brass chandelier hanging from the ceiling, and over to the grand marble staircases which rose up from either side of the room. As I waited to be brought to the third floor for a job interview, I began to look more closely at the chandelier above my head. There was a peculiar-looking glass rim around the outside of the fixture, and some etchings in the glass. At first I couldn't make them out, but then upon closer scrutiny I saw a scorpion, a crab, and a bull ... they were the signs of the zodiac. Actually, all twelve were etched in the glass circle.

Then it dawned on me. I was standing inside the most venerable financial institution on the planet – a place where policy decisions would regularly shake markets around the globe. I was in the holy temple of macroeconomic analysis, and yet above me there were not effigies of great economists like Adam Smith, Knut Wicksell or Leon Walras. Nor were there any signs of great statisticians such as George Box, David Cox, or Karl Pearson. Instead there was a scorpion, a crab, and a bull. There might as well have been a Zoltar fortune-telling machine up against the wall. I was mightily confused.

It was only after many years of watching Fed economic projections, both from the inside and the outside, that I realized how important those zodiac signs really were. The reality is that the Fed is awful at forecasting macroeconomic aggregates. From the failure of Phillips curve models in '70s and '80s, to the consistently overoptimistic expectations for real growth that have plagued recent forecasts, Fed models failed at almost every turn of the postwar business cycle. Of course this problem is not just confined to the Fed: the OMB, CBO, and CEA all have terrible track records. In fact, since their founding, not one of these esteemed institutions has ever forecast a recession one year ahead. So it should really come as no surprise that astrological signs adorn this gorgeous Beaux Arts structure at 20th and Constitution Avenue. Galbraith was absolutely right!

So as we traverse the final months of 2013, eagerly feeding on both the economic data and the Fed's interpretation of the economic data, it is important to step back and understand the shortcomings of this entire exercise. The basis for Fed policy thinking centers on macroeconomic forecasts – numbers with immense standard errors. In fact, the current "Evans Rule" is based on 2-year-ahead "Committee" inflation projections. And to that end, based on the solid work of Rochelle M. Edge, Michael T. Kiley, and Jean-Philippe Laforte in their 2010 piece "A comparison of forecast performance between Federal Reserve staff forecasts, simple reduced-form models, and a DSGE model," it appears that a simple AR(1) forecasting model has far better capabilities than the FRB/US model. That sad fact should constantly remind us of the significant scope for policy errors going forward.

But we should not fret too much about forecasting and policy mistakes. As much as Janet is a model and forecast junkie, she brings into the Board room many of the finer qualities of her predecessor. She understands the toxic potential for debt and deflation to combine, and she too will do anything and everything to fight a debt/deflation spiral. Her forecasts and her optimal control exercises may lead her astray by allowing too much inflation into the system, but there is NO chance she will err on the side of allowing too much deflation. The debt/deflation Tarrot death card will never be turned over at the Board table.

As such, there are two baseline outcomes going forward: either Janet generates modest inflation and strong real growth (no mistake) or Janet generates a lot of inflation and subpar real growth (a mistake). We either get a version of the '90s or the '70s, but NEVER the '30s. Our simple reality is that Janet will jam enough Jello shots down our throats to ensure significant increases in nominal GDP. The sizes of the real and inflation components of this GDP number are all that is up for debate. My personal guess is we end up in a '90s-lite scenario, one with decent real growth, but inflation that annoyingly persists at elevated levels. But who knows – that's just a guess.

The good news is that as long as we are pushing nominal GDP to elevated levels, it does not really matter which scenario unfolds. Long equity capital and long real estate positions should do just fine in either case. And Janet will most likely keep short rates too low for too long. Cash of course is the enemy, and risk-free fixed-income investments (both short- and long-duration) will generate large-scale long-term real losses for their holders. All that said, there is only one simple astrological truth as we look ahead into the crystal ball - the stars remain aligned for spoos and chartreuse. Good luck trading.

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