US Federal Reserve Building in Washington, DC
Vin McNamee | reuters
On Wednesday the Federal Reserve will publish its latest economic forecasts. Close attention will be paid to the summary of economic projections, which are the Fed’s own projections for GDP growth, the unemployment rate, inflation and the appropriate policy interest rate.
The summary will be released as an addendum to the statement following Wednesday’s Federal Open Market Committee meeting.
Investors will study these estimates carefully, and they will likely drive the market.
But should you change your investment portfolio based on the Fed’s projections? You probably shouldn’t.
The Fed’s poor forecasting record: an example
Larry Swedroe, head of financial and economic research at Buckingham Strategic Wealth, has spent decades studying economic forecasts from everyone from stock-picking gurus to the Federal Reserve.
Here’s his advice: Don’t base your investment decisions on what the Fed says. Or anyone else for that matter.
Swedroe recently wrote an article where he looked at a simple metric: the Fed’s effort to predict its interest rate hikes for 2022.
Swedroe said that at the end of 2021, the Federal Reserve estimated it would need to raise rates three times and that its policy target rate would end 2022 below 1%.
what actually happened? The Federal Reserve raised the fed funds rate seven times in 2022, ending the year with a target rate of 4.25%-4.50%.
Federal Reserve: 2022 meetings
(Rates increase at each meeting, in basis points)
- December 14 – 50 BP
- November 2 – 75 BP
- September 21 – 75 BP
- July 27 – 75 BP
- June 16 – 75 BP
- May 5 – 50 BP
- March 17 – 25 BP
What happened? How could the Fed be so wrong? It simply miscalculates the rate of inflation.
“The surprise, at least for the Fed, was that inflation was much higher than it had forecast,” Swedroe wrote. “The December 2021 forecast for 2022 inflation was between 2.5% and 3.0% for core CPI. Inflation more than doubled this.”
If the Fed can’t fix it, what hope do we have?
This has an impact on forecasting in general. Swedroe, along with many others, has long noted the poor track record of stock market forecasters. But the Federal Reserve is a special case: “One might assume that if anyone could accurately predict the path of short-term interest rates, it would be the Federal Reserve—not just professional economists who have access to massive amounts of economic data. , but they set the fed funds rate.”
Yet the Fed has a poor track record in predicting not only interest rates, but other issues such as GDP growth. I discuss this in my book, “Shut up and keep talking: Lessons on life and investing from the stage of the New York Stock Exchange.” The Fed’s own research staff studied the Fed’s economic forecasts from 1997 to 2008 and found that the Fed’s predictions for economic activity for a year were no better than the average benchmark predictions.
How does this happen? There are two problems:
1) the predictions of the Fed and everyone else are full of bias and noise that limits the quality of those predictions; And
2) Lack of complete information, because events occur that are unexpected and may affect the results.
All this should make everyone much more modest about forecasts, and less eager to make sudden changes in investments. The key to investing is to know your risk tolerance, plan for the long term, stay invested and avoid market timing.
Swedroe’s conclusion: “If the Federal Reserve, which sets the fed funds rate, can be so inaccurate in its forecasts, it is unlikely that professional forecasters will be accurate in their forecasts.”
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