What If The Fed Is Completely Wrong About Inflation Again?

From Mike Burnick: Wednesday’s Federal Reserve policy meeting triggered some volatile swings in markets, including a 118-point dive in the Dow Jones Industrial Average, which had been on a moonshot move to the upside since Election Day.

The reason for the reversal: Fed policymakers signaled a faster trajectory of interest rate hikes next year … but don’t bet on it!

The Fed’s interest rate projections couldn’t hit the broad-side of a barn this year. So why overreact to forward-looking guidance, which has been consistently off the mark.

OK, I’m willing to give some credit where credit is due.

According to Bloomberg, SOME of the Fed’s fearless forecasts have been good this year … except for the forecast that mattered most to investors … the path of interest rates.

Several times every year the Fed releases detailed estimates of where they see the economy headed, and the likely path of the short-term Fed funds rate.

One year ago, the Fed forecast 2016 GDP growth of 1.9%. While the final numbers aren’t in just yet, GDP growth is actually tracking at 1.6% year to date.

And the closer-to-real-time estimate of the Atlanta Fed’s GDP Now estimate is predicting 2.4% for the fourth-quarter of 2016.

Blend these numbers together and the Fed’s GDP forecast made in December 2015 is as close to a bull’s-eye as economic forecasting gets. Close enough for government work anyway.

At the end of 2015, the Fed also expected inflation to trend higher this year. It has, with core inflation up 2.1% year over year and accelerating over the past several months.

But the one forecast the Fed got hopelessly wrong is ironically, the one they have the most control over, and investors count on the most: Interest rates.

One year ago in December 2015, when the Fed raised benchmark interest rates by a quarter-point – for the first time in nearly a decade – they also forecast four more interest rate hikes in 2016, according to their infamous dot-plot.

Now, as a rule of thumb, higher interest rates cause investors to discount the value of the profits and dividends stocks earn. So generally speaking, higher rates equal lower stock valuations.

It’s no surprise then why stocks suffered an adverse interest rate reaction, with the Dow plunging about 2,000 points after that December 2015 rate hike, until stocks bottomed in February.

But lo and behold … the Fed was dead wrong about rates.

Yesterday, the Fed raised rates again by a quarter-point … but it was the one-and-only rate hike of 2016!

What happened to the four rate hikes forecast by the Fed a year ago? Blame it on Brexit, or China’s currency devaluation, the election, you name it.

The Fed’s mandate is supposed to be all about promoting stable prices and full employment, here at home. But the reality is that anytime there is a perceived threat to economic stability anywhere in the world – the Fed chickens-out when it comes to interest rate policy.

Yesterday markets sold off because the Fed may hike rates more than expected in 2017. I’ll believe it when I see it. Here’s the reality: The Fed is just as likely to be one-and-done again next year, as they are to hike rates even more than expected. There is just no telling, so I’m not going to lose any sleep over it.

Ironically, the Fed was far too bold in their rate forecast a year ago. Perhaps the biggest risk in 2017 then is that the Fed now underestimates inflation, is behind the curve already, and forced to raise rates even more than expected in 2017.

The iShares Barclays 20+ Year Treasury Bond ETF (NASDAQ:TLT) fell $0.11 (-0.09%) to $117.30 per share in premarket trading Friday. Year-to-date, the largest ETF tied to long-term Treasuries has fallen 2.63%.

TLT-2016-12-16

This article is brought to you courtesy of Money And Markets.

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