Republican presidential candidate and former US President Donald Trump gives a thumbs up after speaking at a campaign event in Rochester.Photo/Charles Krupa for The Associated Press
opinion
Should the Fed lower interest rates in March? Looking at the so-called Taylor Rule, named after legendary American economist John B. Taylor, the answer is a resounding yes. .
After all, this formula, which uses variables such as the price level, unemployment rate, and real income to predict the optimal interest rate, is now, as Chief Economist Torsten Slok puts it, “today’s federal funds This means that the interest rate should be 4.5%, not 5.5%. Apollo writes:
That’s a big gap. No wonder the market has moved in a direction that suggests there will be six rate cuts in the US this year, with a 70% chance of them starting in March.
But if you had listened to the chatter emanating from last week’s World Economic Forum, the answer would be very different. “It’s too early to declare victory.” [over inflation]” François Villeroy de Galhau, governor of the French central bank, told participants in Davos. “The work isn’t done yet.”
Or, as Philipp Hildebrand, former head of the Swiss central bank and current head of BlackRock, puts it: So optimism, especially on US interest rates, is probably overdone. ”
We can infer from statements like this that some people think Taylor’s law is wrong or best ignored. Does this matter? Cynics might say no. Central bankers have always disliked the idea of taking control of markets, and many economists believe this once-sacrosanct rule is overly crude.
But in my opinion, this discrepancy points to a larger issue that investors need to ponder. Will political factors dominate economic fundamentals in 2024 or vice versa? Or, to put this in monetary policy terms, will this year’s inflation be primarily shaped by the demand cycle and economic fundamentals, or will supply-side issues, often associated with politics, dominate? ?
Until recently, most central banks and economists assumed that the demand cycle was most important. That’s why neat models like the Taylor rule, which use past data about economic fundamentals to predict the future, are widely used.
However, the coronavirus upended this sunny confidence, as supply chain shocks led to a spike in inflation in 2021, followed by a fall in 2023 when the shock abated. To be fair, demand was also important. As a recent blog from the White House Council of Economic Advisers noted, the coronavirus fiscal stimulus boosted demand in a way that contributed to higher prices. Last year’s rate hike did the opposite.
But the CEA, using Janet Yellen’s research before she became Treasury secretary, calculates that 80 percent of recent disinflation is due to supply fluctuations. Of course, these are outside the Fed’s control, and so is its model.
This is humiliating for central bankers. The same goes for business leaders. For example, back in January 2023, I asked a group of top executives to predict US inflation trends. Most predict that it will exceed 6% in 2024, far exceeding the current 3.4%.
The good news is that some economists are changing their models in response. For example, Chicago Booth’s Elisa Rubbo has developed a “God’s coincidence index” that tracks supply shocks alongside demand changes in inflation forecasts.
But the bad news is that this research is still in its infancy and has not been formally incorporated into central bank models. So the important questions are: How will these demand and supply patterns play out in the United States and the rest of the world in 2024?
If you are an optimist who cares about economic fundamentals (as many of the Davos participants were), you would think that the demand cycle is in control. After all, the coronavirus lockdown is over and companies are now more adept at dealing with supply chain shocks, such as the loss of Russian gas or disruptions to shipping. In fact, a Bank of America poll shows that a majority of global investors expect a “soft” landing or better in 2024, the most optimistic outlook in nearly two years. This is a realistic number.
But if you are a pessimist, you cannot ignore political issues. Geopolitical conflicts are already driving up transportation prices. Take the recent attack by the Houthis in the Red Sea. And while its immediate impact is mitigated by the fact that shipping volumes typically fall in January, the World Bank recently reported that the global supply chain stress index is rising and that any disruption in the Red Sea could It warned that it could repeat the pattern last seen during the pandemic. continue.
Other conflicts pose a threat, as do domestic politics. For example, Bridgewater’s Greg Jensen believes investors are “undervalued.”[ing]” If President Donald Trump is presumed to win, there could be a threat of inflation. Because President Trump will likely appoint a docile Federal Reserve, impose high trade tariffs, and institute expansionary fiscal policy.
Of course, central bankers themselves are not allowed to factor such risks into their models, at least not officially. But this kind of risk explains why the mood music of Davos is at odds with market prices. And it illustrates his two important lessons. The first is that economists in all disciplines urgently need to study supply-side issues, not just the demand cycle. And second, it would be wise for CEOs and investors to hedge this year. The range of potential outcomes is very wide.
Author: Gillian Tett.
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