When the Federal Reserve raises interest rates on Wednesday, they’ll be doing so in the face of an unwelcome economic reality: many of the inflationary forces they had long expected to fade have persisted, with some worsening.
As the economy has recovered from pandemic shutdowns, central bankers have routinely misjudged how high inflation would climb and how long it would stay. They’ll issue a new set of quarterly economic estimates on Wednesday, with inflation expectations expected to be raised for the sixth time in a row. Don’t worry, I’ll cover that tomorrow or Thursday when those economic estimates release.
Now, as the Federal Reserve prepares to launch a series of rate hikes in an attempt to bring inflation down, authorities appear to be aiming at a changing target once again. The Russian invasion of Ukraine and sweeping lockdowns in China have thrown supply chains further into turmoil, lengthening delivery times and increasing the price of many goods. Many of these shortcomings in deliverables are stemming from the war obviously, as US sanctions continue to limit world trade. In the epicenter of Europe and Asia, the absence of flights and decreasing ocean shipments continue to threaten supply chains in palladium, nickel, and wheat. Obviously, there has been a massive increase in the price of energy across the board.
But it isn’t just the war causing these issues. In recent days, even as early as this morning, cities and provinces across China have implemented broad lockdowns (again) in an attempt to halt the spread of the Omicron variant of Covid-19. On Sunday evening, Shenzhen, a powerhouse of electronics production and a major seaport with a population of 17 million citizens, announced a seven-day lockdown. Foxconn, an electronics company that supplies Apple from its plants in Taiwan, has announced that it would stop operating as a result.
When asked, chief economist at the logistics firm FlexPort, Phil Levy said:
“The question is whether this is going to be bad or very bad…If things get gummed up there, it will reverberate through the whole system…these problems just build”
Interest rates are pretty favorable currently and have been for a while. The inverse reaction to this has sparked one of the best housing sellers-markets in history, as buyers know locking into a low-interest mortgage is obviously ideal. Interest rates have indeed been kept near zero by Fed policymakers since March 2020, and they are likely to be raised for the first time since 2018 on Wednesday. The Fed hopes to decrease demand and rein in inflation by making money more costly to borrow and spend, so encouraging circumstances to balance out at a time when a return to “normal” has proven painfully, and routinely, difficult.
One of the things I have noticed, at least in recent months, is the lagging indicators of the markets and the world economy, in relation to how forecasters ‘price to perfection’. Now I am not the first person to take note of this, but it is a good concept to grasp in our never-ending strive to interpret economics. Indeed, Harvard professor Jason Furman just recently touched on this. But here is a brief explanation:
The basic efficient market theory is a predictor that all known information about the probable future is already reflected in the prices. This is also known as ‘priced to perfection. Meaning, the investments earn a higher than normal valuation based on optimistic expectations. Basically, the price of an investment or asset is higher based on the expectation of how said asset will perform if the company were perfect. When someone says “I want to buy X company stock because I think they will perform well”, the price of X company’s stock is most likely already reflecting that prediction. This is why when slightly negative reviews come out, the price falls dramatically as investors question their performance.
This can be true for economists, and yes, even the federal reserve. Part of the economy and actions taken by the fed are taken in a ‘pricing to perfection’ approach. Personally, and i think most everyone would agree, the economy did pretty well during the pandemic. We were seeing record closes day after day in the markets. And even though we saw a decline in spending across key areas, the relative economic outlook was pretty favorable. This ‘pricing to perfection’ worked out well for us here in the States. The government, and even the general public, were projecting a short-lived shutdown period and therefore, prices reflected those expectations.
But that hasn’t been the reality. As I mentioned before, most of the economy is built upon projections and is either confirmed or denied with lagging indicators after those time horizons pass. In many respects, the developments of the previous several years have been so unexpected that few, if any, analysts have been able to accurately foresee them all. Officials from the Federal Reserve have admitted that they underestimated inflation last year, partially because they anticipated supply chains to rebound faster.
Jpow, the fed chairman said earlier this month, “We haven’t seen much relief on the supply side”, referring to the Ukraine war and its new threat to the world economy. Mr. Powell projected that when the Federal Reserve does raise rates this year, it will help to cool demand for auto loans and mortgages, reducing consumer spending and providing businesses some room to breathe to catch up with demand. Central banks around the world hope that the economy is “returning to normal” in terms of supply networks and the breakdown among products and services in accordance.
If anything is true, it’s that the events around the world currently make it a little easier to predict economic projections. War isn’t great. Shutdowns aren’t great. And with this climate we are in, we will have to see when Jpow and his friends decide to raise hights and if the ‘pricing to perfection’ continues. The markets are more reflective of the truth now. Yet, it remains to be seen if the inflation issue will be curved through natural degression of war and shutdowns, or if the Fed will step in and be more aggressive towards generating price stability.
More later this week as those quarterly economic projections are released.