Feddle not Wordle

3 Feb

Chief Global Strategist at J.P. Morgan Asset Management

In the last few weeks, it seems everyone is playing Wordle. Each morning, a UK website posts a new game and you get six attempts to guess the five letter word. If you guess the right letter in the right square, the square turns green. If you get the right letter in the wrong square, the square turns a mustard yellow. If you get it all done in four tries the program says “splendid!” If it takes you six tries, it says “phew”. It’s a nice distraction in what we all desperately hope are the waning days of the pandemic. It’s also not particularly difficult, provided the right answer doesn’t include too many rare letters.

Once a quarter, the members of the Federal Open Market Committee play a similar game, which I think I’ll call Feddle, in which they try to guess some key economic variables for the fourth quarter of upcoming years. In particular, they focus on year-over-year real GDP growth, the unemployment rate and year-over-year consumption deflator inflation.

In 2021, the game proved to be harder than it looked as virus variants and fiscal stimulus simultaneously tightened supply and boosted demand, and pandemic conditions and weak demographics reduced labor force growth. In the end, the Fed, like many private forecasters, (including yours truly), overestimated unemployment and seriously underestimated inflation.

However, in economic forecasting, as in sports, there is always next year. So what does the Fed expect for 2022 and how realistic are their estimates?

On year-over-year real GDP growth in the fourth quarter of 2022, the median forecast of FOMC members in December was 4.0%.

On balance, this projection may turn out to be too optimistic.

On the consumer side, fewer supply chain disruptions should allow for a surge in auto sales and increased spending on leisure, dining and entertainment. However, many areas of services spending will be constrained by a lack of workers and less federal aid should hurt spending at grocery stores.
Investment spending should also be a mixed bag with strong gains in equipment, intellectual property and the energy sector being offset by weakness in some areas of commercial construction. Home-building should be strong, despite higher mortgage rates, as builders respond to very low inventories of homes for sale.
Companies will very likely rebuild inventories throughout the year. However, it is very unlikely that the pace of inventory rebuilding by the end of the year will match the enormous $174 billion increase in real inventories seen in the fourth quarter of 2021, making inventory growth, oddly, a subtraction from GDP growth in the year ahead.
Meanwhile, U.S. trade numbers could well deteriorate further as consumers finally get their hands on back-ordered imports and the real value of the dollar, boosted both by nominal appreciation and higher U.S. inflation, makes U.S. goods even less competitive in global markets.
Finally, government spending is likely to be constrained. On the federal side, the Administration’s difficulty in passing the President’s Build Back Better plan should contribute to significant fiscal drag following huge spending over the pandemic. On the state and local side, lack of flexibility in wages may well continue to frustrate attempts to rebuild payrolls, despite much better fiscal positions.

Adding it all up, real GDP growth in the year ending in the fourth quarter of 2022 looks more likely to come in at 3.0% than 4.0% - still strong, but clearly a deceleration from the 5.5% real growth achieved over the past four quarters.

On the unemployment rate in the fourth quarter of 2022, the median forecast of FOMC members in December was 3.5%.

This could prove to be pretty accurate. The unemployment rate in the fourth quarter of 2021 was 4.2% but this masks a sharp decline from 4.6% in October to 3.9% in December. This Friday’s jobs report may show that pandemic disruptions pushed the unemployment rate back to 4.0% in January. However, there are currently 10.6 million job openings for just 6.3 million unemployed workers. This unprecedented excess demand for labor is leading to higher wages and will likely whittle away at the ranks of the unemployed throughout 2022, particularly with the expiration of federal enhancements to unemployment benefits and the fading of pandemic distortions.

On year-over-year consumption deflator inflation for the fourth quarter of 2022, the median forecast of FOMC members in December was 2.6%.

At first glance, this may seem to be a bizarrely low number, given that consumption deflator inflation was 5.5% year-over-year in the fourth quarter of 2021. However, there really are grounds for expecting an easing in headline inflation. In particular,

Oil prices averaged $77.45 for a barrel of West Texas Intermediate Crude in the fourth quarter of 2021. While prices are at even higher levels today, these higher prices are likely to prompt stronger production, leading to lower oil prices by the end of the year.
The December CPI report showed new and used vehicle prices up by 11.8% and 37.3% year-over-year respectively. Both of these numbers could show declines by the fourth quarter of this year as auto companies work their way out of current chip shortages.
Grocery-store food prices were up 6.5% year-over-year in December. This was partly due to supply-chain problems. However, it also likely reflects the impact of a 9.7% increase in real consumer spending in this category over the past two years, bolstered by generous government pandemic assistance. As this money dries up, the shelves will likely get restocked and food prices should grow much more slowly in the year ahead.

This being said, significant inflationary pressures are likely to persist due to stronger gains in wages and owners’ equivalent rent. In addition, inflation psychology has, to some extent, taken hold and this could add to inflation pressures for a while. However, the bottom line is that, as the economy cools, most of the excessive inflation we have seen recently should subside.

The Risk of a Policy Mistake

As noted earlier, the Federal Reserve releases these forecasts once a quarter and the title of the table in which they are published notes that the projections are based on the assumption by each participant of “appropriate monetary policy”.

It is an interesting caveat and an important one today. There are clearly many risks to any economic forecast including new variants of the virus, geopolitical concerns and domestic political issues.

However, one of the greatest risks is that the Federal Reserve turns too active in its new-found zeal to defeat inflation. The recent surge in CPI inflation is not, in fact, of the Fed’s making, having more to do with supply-chain problems caused by the pandemic and generous federal government aid. These inflation pressures should, to some extent, ease in the months ahead.

The Federal Reserve is, however, responsible for feeding asset bubbles in housing, parts of the stock market and across a wide swath of speculative investments and they need to steadily normalize policy to gingerly remove some of the air from these bubbles.

However, if they instead embark on an aggressive attack on inflation starting with, for example, a 50-basis point fed funds increase that some are predicting for March, they risk precipitating a crash in asset prices and greater weakness in economic growth. This could, in turn, interrupt their normalization, which would be particularly unfortunate since it would take many years of steady uninterrupted tightening to actually bring monetary policy back to balance.

For investors, it is worth thinking about the consequences of both Federal Reserve success and failure.

The economic numbers projected by the Fed for this year are actually excellent by historical standards. No one should be unhappy about 4% real GDP growth, 3.5% unemployment and the slight blemish of 2.6% inflation. If this is achieved as the Fed tightens, then long-term interest rates will likely be higher by the end of the year, favoring assets with lower valuations over those which have been inflated by excessive liquidity in recent years.

However, if the Fed fails by trying to fine-tune the business cycle with overly aggressive tightening, it is also those assets with the highest valuations that are most vulnerable. This suggests that whether the Fed forecasts for 2022 turn out to be on the mark or not, the most logical strategy for investors is to focus more intently on valuations and balance in the year ahead.

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