Don’t Put Too Much Stock in Central Banks’ Forecasts

Will the European Central Bank (ECB) raise interest rates sooner than expected? Some pundits think so, based on a recent Financial Times report. The paper reported the ECB anticipates hitting its 2% y/y inflation target by 2025 based on internal, unpublished research. According to some pundits, if this projection lands true, that would fulfill the ECB’s purported conditions for considering raising interest rates—which means an ECB rate hike could be coming by the end of 2023. That may sound distant, but to hear pundits tell it, it is much earlier than most analysts expect, sending some scampering to recalibrate. However, we caution investors against putting too much stock into central bankers’ forecasts—they aren’t blueprints for future monetary policy.

An ECB spokesperson promptly refuted Financial Times’ conclusions, saying, “The conclusion by the FT that a lift-off of interest rates could come already in 2023 is not consistent with our forward guidance.” ^[i] The spokesperson added that ECB chief economist Philip Lane—the person who disclosed the internal findings on a private call—refrained from specifying a particular date the ECB would reach its target. However, the ECB’s comments seemed to just add more fuel to the fire. Following the revelation, a former ECB official argued any internal research should be taken with a “pinch of salt,” while an industry expert suggested the findings implied ECB wasn’t as transparent as they claimed—potentially unsettling to investors.^[ii]

In our view, this hullaballoo reveals monetary policy decision-making isn’t a clear-cut process. Rather, central bankers are considering a host of information, including internal research. The ECB’s economists are likely running through myriad scenarios and hypotheticals that could influence policymakers’ thinking. However, these additional inputs don’t necessarily make the ECB any better at forecasting.

Consider the Eurosystem staff’s—which comprises both the ECB and the eurozone’s national central banks—three-year forecast from December 2016. (Exhibit 1) Their estimates for 2017 – 2019 were occasionally close—and occasionally far off.

Exhibit 1: The Eurosystem’s Three-Year Projections From December 2016

Source: ECB and Eurostat, as of 9/20/2021. Eurosystem staff’s December 2016 eurozone macroeconomic projections for 2016 – 2019 and annual percent change in eurozone HICP and GDP, 2016 – 2019.

This isn’t unique to the ECB. Other central banks also make economic projections, and their success rate isn’t stellar, either. Exhibit 2 highlights the BoE’s medium-term projections from its November 2016 “Inflation Report,” while Exhibit 3 shows the Fed’s estimates following its December 13 – 14 meetings the same year. Sometimes they overshoot, sometimes they undershoot, but rarely do they get it exactly right—especially further out in the future.  

Exhibit 2: The BoE’s Three-Year Projections From November 2016

Source: Bank of England’s Inflation Report: November 2016 and FactSet, as of 9/20/2021. Calendar-year growth in real GDP and year-over-year change in CPI, 2016 – 2019. Note: Inflation data here reflect percent change from the fourth quarter of the previous year to the fourth quarter of the indicated year.

Exhibit 3: The Fed’s Three-Year Projections From December 2016

Source: US Federal Reserve and FactSet, as of 9/20/2021. Fed projections based on “Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents under their individual assessments of projected appropriate monetary policy, December 2016.” Change in GDP and inflation are percent changes from the fourth quarter of the previous year to the fourth quarter of the indicated year. Inflation metric cited here is the personal consumption expenditures (PCE) price index.

Note, we aren’t knocking central bankers for this—divining the future is no easy task. However, the myopic focus on central banks’ projections ties back to the foolhardy effort to predict monetary policy. Some pundits see monetary officials’ forecasts as a roadmap to future policy: e.g., if central banks project a certain inflation rate, investors can correctly guess policy decisions in advance—especially if the bank has set specific criteria for making certain moves. Yet this relies on many presumptions. Beyond the forecasts being correct—which they often aren’t—policymakers will then have to act in a predictable manner. Yet central bankers have a history of changing their minds even after data reach their self-imposed thresholds. Former Fed head Janet Yellen and former BoE Governor Mark Carney blew through the unemployment rates their central banks’ guidance said would trigger rate hikes without hiking at all. Yellen also commented in 2014 that an initial rate hike would occur some six months after quantitative easing’s (QE) end. (The Fed didn’t hike rates until more than a year later.)

Note, too, markets don’t have pre-set reactions to central bankers’ decisions. Consider rate hikes, which many view as an automatic negative since monetary “tightening” allegedly means central bankers are making it more difficult to borrow. This development dominated headlines in 2015 as experts worried the Fed’s first rate hike of that cycle would stoke volatility and ripple globally. We thought those fears were overwrought at the time, and we now have another bit of data debunking the concern: the history immediately following the Fed’s initial rate hike in December 2015. In the six months following that rate hike, the S&P 500 rose 1.4%; 12 months later, returns improved to 11.3%.^[iii] US GDP grew 1.7% in 2016.^[iv] Overall, returns after initial rate hikes are routinely positive—and our research shows first rate hikes have never ended a bull market. This doesn’t mean rate hikes are always and everywhere a positive. Rather, we think it illustrates a broader point: If there is no pre-set reaction to monetary policy, trying to predict central bankers’ actions based on myriad shifting variables seems like an unnecessary exercise for investors—their time would likely be better spent elsewhere, in our view.