One of the most amusing things about market commentary is that because economics is arguably the “softest” of the “soft” sciences, you can pretty much spin whatever narrative you want to spin at any given time.
Economists – especially the ones who take themselves too seriously, which is most of them – would invariably argue that the above characterization is upside down. That is, they might well tell you that when it comes to “soft sciences”, economics is the “hardest” of the lot. I don’t think that’s the case, and I’m formally trained in both economics and political science, so I’ve got a leg to stand on here.
To the extent you can measure the “hardness” of a “science” by the extent to which practitioners agree on important points, economics is pretty damn soft. I mean don’t get me wrong, there are some cases where something flies so blatantly in the face of common sense that it engenders broad-based agreement from the economic community on at least a few points. For instance, there’s broad-based agreement that fiscal policy in the U.S., whatever it accomplishes in the short-term, is likely to be viewed in hindsight as poorly timed in terms of the longer-run implications. But I’ve been out drinking with economists. And I’ve been out drinking with political scientists. And sometimes the political scientist crowd would bring sociologists along for the drinking. And I can tell you definitively (to whatever extent anecdotal evidence gathered while drinking can be accurately described as “definitive”) that the chances of the drunken discussions devolving into physical altercations were materially higher with the economists than they were with the political scientists and the sociologists and that’s not because economists are predisposed to violence.
The funniest thing about this setup is that people make real-time decisions about money based on things economists do and say. And then people argue about those decisions which means that before long, you’ve got an entire financial system built on a soft science and decisions people have made based on economists’ interpretation of a science that is about the furthest thing from “exact” imaginable. In short, it’s all made up.
Of course everyone knows that at some level, right? I mean my professors knew it back in the day. That’s not to say they weren’t pompous (they were) and it’s not to say they hadn’t duped themselves into believing that their interpretation of an inherently imperfect science was better than the guy down the hall’s interpretation of that same inherently imperfect science. It’s just to say that they all know, even if they don’t admit it, that this shit ain’t rocket science – and I mean that literally here. It’s not determinant in any sense of the word and at the end of the day, you can’t even depend on it to tell you if the housing market is about to collapse let alone depend on it to fly your ass to the literal moon safely.
This makes it especially precarious to try and “forecast” what the Fed is likely to do when presented with a given trend in the data. The data is itself imperfect and the people making decisions based on that data are trained in a “soft” science and the people trying to guess what those decisions are likely to look like are basing their guesstimates on their own interpretation of that very same “soft” science and on top of it all, there’s a reflexive character to the relationship between everyone involved and market participants (i.e. market moves influence policy and vice versa).
So that’s the kind of humorous backdrop against which everyone is attempting to analyze the incoming inflation data and determine whether and to what extent the market’s schizophrenic reaction to that data will influence Fed economists’ interpretation of the very same numbers. It’s a dizzying clusterfuck that would seem patently absurd to laypeople, which underscores something I tweeted the other day about how the FinTwit community doesn’t seem to appreciate how silly they all sound when they debate all of this in real-time in a public forum.
With all of that in mind, I wanted to present a couple of excerpts from some commentary out of Barclays that someone sent over this weekend. As far as I can tell, this is a bit dated, but it speaks to everything said above for obvious reasons…
Federal Reserve Commentary: Normalization plans to remain in place despite uptick in financial stress
US equity markets falling into correction territory in recent days begs the question of how far equities would have to fall, or volatility to rise, for the Fed to consider a delay to its policy plans. We think it is too early for the Fed to consider altering course and we believe the committee will likely take some comfort in the tightening in financial conditions as it will reduce the risk of a hard landing over time. The Fed can be patient, to see whether market volatility weighs negatively on activity; sizeable fiscal stimulus awaits and will likely dwarf any stress-induced slowdown. While we remain attuned to any signs that household spending, business investment, and hiring are weakening, we expect fiscal stimulus to keep the US economy growing above trend. We maintain our outlook for a 25bp increase in the target range for the federal funds rate in March, and for four rate increases in 2018.
Equity declines and market volatility can affect activity primarily through two channels. First, falling equity valuations can have negative consequences for private consumption through negative wealth effects. Just as persistent increases in net wealth can lead to higher ratios of consumption out of current income (eg. a lower savings rate), large declines in equity valuations can lead households to reduce their assessment of their wealth and, in turn, reduce consumption in favor of saving. A key factor here is whether households view the change in wealth as permanent in nature. Shocks to wealth that are viewed as transitory are not likely to alter household spending plans.
Second, we find that periods of increased financial stress can weigh on hiring, business spending, and economic activity. Negative shocks to financial stress can begin to weigh on activity with only a 1-2 quarter lag, while changes in financial conditions do not kick in until after about eight quarters. This discrepancy between the immediacy of the effects of stress and the delayed response of activity to financial conditions is broadly consistent with the Federal Reserve’s view that monetary policy acts on the real economy with long and variable lags.
In our view, it is too early for the Fed to alter course. The decline in equity markets is likely not large enough or long enough to lead households to conclude that changes in wealth are permanent. In addition, we see little to no evidence to suggest that higher volatility has slowed the pace of economic activity relative to prior months. The increase in stress – if sustained – will likely have some effect on economic activity, but we think it remains too early for any firm conclusions to be drawn. The recent market moves also do not have the characteristics of risk-off episodes of years past. In previous bouts of volatility, equity markets fell, Treasury bonds rallied, and the dollar appreciated. This was the common pattern across the European sovereign debt crises, the US fiscal cliff, and the China-induced volatility in 2015. Yet, US Treasury yields have generally risen in recent weeks and the dollar remains well below year-ago levels. In our view, the Fed is likely to read recent market movements as indicative of a repricing around solid macro fundamentals as opposed to a sudden loss in confidence.