‘The Economy Is Both Booming And Headed For Recession’: The Fed And Schrödinger Plates

A fixture of debates about the relative merits of Fed cuts in the current environment is the paradox of conflicting data, some of which suggests the US economy is rolling over, some of which suggests it’s not.

This is something that’s vexed Fed officials and while there are a number of ways to illustrate it, a simple visualization might simply show, on one hand, unemployment loitering at a five-decade nadir and, on the other, manufacturing surveys diving to Trump-era lows amid trade uncertainty.

Jerome Powell has, of course, spent quite a bit of time documenting the extent to which the data has a habit of sending conflicting signals. Trump’s trade policies cloud the outlook for corporate America and also for the Fed. With respect to the latter, there’s an argument to be made that the president is deliberately muddying the waters to engineer easier monetary policy.

The premise behind so-called “insurance cuts” is that the Fed can get out ahead of things by lowering rates now. Acting preemptively would have the added benefit of guarding against further undershoots of the inflation target. But part and parcel of this whole debate is that, assuming any such preemptive rate cuts “work”, we’ll never know if they were, in fact, necessary.

“The economy at the moment is in a superposition of two states — it is both booming and it is headed for a recession”, Deutsche Bank’s Aleksandar Kocic writes, in his latest note. “The two states of the economy are entangled.”

Kocic frames the current dilemma as a “Schrödinger plates” scenario. Here he is recapping for anyone who doesn’t immediately get the reference:

To illustrate the current dimension of uncertainty, imagine a situation where we are alerted by a sudden crashing noise coming from our kitchen cabinet where our dining plates are stored. What happened inside the cabinet — the configuration of the plates — is shown in the figure (for historical reasons this problem is referred to as Schrödinger plates). For the sake of argument, we assume that the cabinet doors are made of wood and we cannot see what is happening inside. Did the plates break or are they intact? If we open the door to check, the plates will fall out and break. If, on the other hand, we do not open the door, they might be intact, but we will never know. The plates are in a superposition of two states: broken and unbroken.

In the context of the Fed and “insurance cuts”, this takes a simple form. As Kocic writes, “if the Fed does not cut rates (we open the door), the recession is likely [while] if the Fed cuts rates, (we do not open the door), the recession is averted, but we wouldn’t know if the cuts were needed.”

In both instances the Fed is interfering, and that interference has ramifications. Not acting risks a recession and everything that comes with it. Acting (i.e., cutting) comes with its own set of potentially dangerous outcomes, including, to quote Kocic, “the loss of central bank independence and potentially another round of trade wars and even more pressure on the Fed to cut rates with further markets addiction to stimulus and possibly higher inflation etc.”

He goes to dissect the dot plot which, of course, was scrutinized even more than usual at the June meeting, as 8 members see a rate cut in 2019, 7 of which see 50bp of cuts. Kocic visualizes the split consensus by bundling the dot plot into two camps, those in favor of lower rates and those in favor of unchanged or higher rates. “The bifurcating consensus then becomes clearly apparent in terms of persistence of roughly 50/50 pattern across different horizons”, he writes.

(Deutsche Bank)

What is the “correct” way to interpret the split consensus? Well, if you have a definitive answer to that, you should definitely let somebody know, because this is a source of vigorous debate, and never more so than now, considering the possibility that cutting rates imperils Fed independence. For his part, Kocic offers the following three possible interpretations:

They do not see more than two rate cuts anywhere on the horizon. This, in itself, could mean three different things: 1) Two cuts are enough to take care of the current situation, i.e. this is not really a recession we are dealing with, but more of a policy tweak. 2) After 2020, we might have a different political configuration. 3) If we read between the lines, this could also be interpreted as an indication that a maximum of two cuts is a signal of how far the Fed is willing to get involved in the policy mix and as a signal they are sending in that direction. This is also consistent with an implicit belief in a likely political compromise.

What’s different about the current state of affairs compared to history? That’s a little easier to answer, actually.

Kocic reminds you that there’s a difference between risk and uncertainty. “In the past, we had dealt almost invariably with risk — the outcomes are unknown, but there was a consensus about probability assignment”, he writes. “Presently, we are dealing with uncertainty, where we have proliferation of possible outcomes, but without proper probability assignment.”

On that note, we’ll leave you with a short, video summary from the wellspring of uncertainty…

Read more on the Fed crossing the “political event horizon“