Data-Dependent Forward Guidance

Entering 2015, many forecast the Fed would start hiking rates mid-year. But only nine trading days in, folks are already singing a different tune, venturing the Fed may push back its rate increase a bit later. What gives? Well, what gave are inflation rates, which data show are down. As are oil prices, suggesting headline inflation rates may move further away from central bankers' target rates, not toward them. And hey, central bankers from both sides of the pond say policy is data-dependent! But the timing of a hike isn't any clearer now than it was entering the year. You see, data may reverse course; central bankers might interpret the data differently; and it could all just be jawboning anyway. This game of gaming a non-gameable body-central bankers-is fruitless for investors. We suggest you opt out.

The Fed and BoE have recently told anyone who'd listen monetary policy would be "data dependent"-rate hikes or policy shifts rely on economic data justifying moves. The inflation rate is just such data. Both central banks target a 2% y/y inflation rate, and the latest readings are below the mark. In the US, the November PCE Price Index-the Fed's preferred inflation gauge-rose 1.2% y/y, a bit lower than October's 1.4% y/y increase. UK CPI slowed to 0.5% y/y in December, further south of the target than November's 1.0% y/y change. As a result, BoE governor Mark Carney has to write a letter explaining why inflation is so low, a reversal from his predecessor Mervyn King, who more often had to explain above-target inflation.

Yet a major reason for this miss is pretty evident: falling oil prices. Excluding volatile food and energy costs, the US PCE Price index rose 1.4% y/y in November, which isn't that much below the target (October was 1.5% y/y). Similarly, UK core CPI rose 1.3% y/y in December, up from November's 1.2% increase. Now, to us, there is nothing magical about reaching 2% inflation. The US and UK have done just fine at current "low" inflation levels. But some rate hike forecasters presume these data will cause central bankers to pause a bit before making any policy changes and conclude a delayed rate hike, from mid-2015 to perhaps a bit later. Some even suggest bankers should consider additional measures to boost CPI.

While changing expectations as data arrive seems rational enough, this assumes inflation remains below target and both the Fed and BoE will act exactly as anticipated. Yet neither is guaranteed. Falling energy prices weighed on inflation gauges, but they're also highly volatile. This is why, historically, central bankers have frequently referred to their influence as transitory (short-term, in non-Fedspeak). Now, we aren't predicting oil prices will suddenly jump in the coming months, but crafting monetary policy based solely on the latest inflation data implies central bankers foresee continued deflationary pressure from falling oil and/or food prices. The latter, for example, would almost require the Fed to have a staff meteorologist, which we are fairly sure they don't.(?)

But also! "Data-dependent" decisions are really "decisions dependent on an interpretation of data." Central bankers are people^[i]-and people have their own biases, ideological bents, opinions and warts^[ii]. Both the Fed and BoE operate by committee, so nobody-not even Janet Yellen or Mark Carney-can unilaterally change policy. Consider recent Fed member statements. One Fed president opposes a rate hike^[iii] until 2016. Another warned the Fed risked "falling behind the curve" if it didn't hike soon. One official said a rate hike would likely "be justified by the middle of the year," while his colleague is waiting for "evidence in wage and price data" before moving. Fed head Janet Yellen has a "dashboard"-several statistics attempting to gauge the labor market's health. In addition to being very backward-looking, a bunch of different indicators gives the Fed flexibility to tell whatever story it wants. The most job openings since 2001? A strong year of hiring in 2014? Evidence of strength! But the underemployment rate is still lower than its pre-recession level? Slow wage growth? Justification to keep rates where they are! You not only need to know the data, you have to know how the data are viewed and which data points the majority of Fed people choose to emphasize.

Here is another wrinkle. While we are darn sure economic data influences monetary policy decisions, central bankers stressing their decisions are "data-driven" could be more "forward guidance." Meaningless marketing spin! An effort to seem scientific, when very little about macroeconomics or monetary policy is really so clear cut as to fit into a clean formula. Consider briefly the Fed and BoE forward guidance's evolution. Both banks pinned initial hike timing to unemployment rate levels-a data point. They subsequently chucked the data point as they drew near. The Fed then pinned it to a timeframe after quantitative easing ended (and later retreated from it), while the BoE flip-flopped over timing. Now both suggest things are data dependent, but they aren't providing much assurance it'll be any more data dependent than the original forward guidance's unemployment rates. By now, these folks' words should carry credibility similar to a boy who said some things about a wolf. Yet many see these words as gospel: analyzing them; diagramming their sentences; trading on them; projecting words to be included or deleted.

Trying to predict the next rate hike is a futile exercise, but it also isn't critical news for investors anyway. Initial rate hikes historically are neither bearish nor bullish, and both the US and UK economies seem easily able handle it.