Investing with imperfect information – Wells Fargo

Research Team at Wells Fargo Securities, suggests that for investors, the challenge is to make decisions under conditions of imperfect information.

Key Quotes

“The volatility of expectations on FOMC actions is an excellent representation of the imperfect information the market has on inflation, inflation expectations and the FOMC’s reaction function to that inflation.

All Gaul Is Divided into Three Parts

One, What Is Our Inflation Model?

The response of labor costs, as measured by wages, has diminished in the current economic recovery relative to earlier cycles. Yet, there is no clear, sharp upturn in wage growth during the current cycle despite the significant decline in the unemployment rate. Therefore, there is no one-to-one correspondence of wage growth and the unemployment rate. Other factors are at work— slower productivity growth and weaker output pricing power come to mind as potential explanations.

Two, Imperfect Information and Inflation Expectations: Unanchored

For both policymakers and financial market participants, the decline of inflation expectations since 2013, as measured by the Fed’s own five-year five-year forward calculation, has led to a steady decline in the yield curve over the same period.

There are two obvious problems for decision makers. First, what is the proper inflation rate to plug into the policymakers’ models for adjustments to the fed funds rate if we are moving the goalposts (2 percent or bust?), and what measure of inflation do we utilize? Second, how responsive is inflation to changes in Fed policy in the context of a global economy where there is perceived excess global supply capacity and thereby less pricing power for businesses and, as a result, less bargaining power for employees?

Three, the FOMC’s Reaction Function

One benchmark for policy, the unemployment rate, has declined to a level consistent with full employment. Meanwhile, a second benchmark, inflation, has continued to rise modestly over the past six months. Yet, the FOMC has lowered its path for the fed funds rate over the same period according to the dot plot. So, what is the FOMC’s reaction function?

There are two issues. First, whatever the historical response of the funds rate to economic signals, that response is now muted and delayed compared to earlier periods. In an environment of full employment and rising inflation, the expectation on FOMC action would be that the FOMC would consider the importance of lags on the timing between policy actions and the impact of those actions on the economy. Yet, the FOMC continues to lower its projected path for the fed funds rate.

However, the second issue is both a new issue and, at least in the short run, probably the overriding issue—global economic and financial developments. While these developments certainly merit consideration in the conduct of monetary policy, they present three issues that widen the range of possible outcomes for monetary policy expectations. First, as evidenced by Brexit, sharp turns in global developments arise in ways quite apart from the underlying expectations of market participants. Second, the inclusion of global developments as a factor is relatively new in the fed funds rate calculus and therefore there is no history of the FOMC’s reaction to these developments. Finally, quite distinct from inflation and the unemployment rate, there is no measureable benchmark for assessing the behavior of “global economic and financial developments.”

Current monetary policy follows a pattern of behavior consistent with the imperfections of information in the current economic expansion but that also do not provide clear guidance to financial market agents. Policymakers have moved the goalposts (e.g. what is full employment?) when policymakers sense that they can pursue a policy to achieve a bit more growth/lower unemployment with only a marginal increase in the pace of inflation. Investors are left with the three fundamental questions. What is the inflation model? How shall we measure and target inflation in today’s global economy? Finally, what is the Fed’s reaction function to the evolution of economic data? We continue to search for answers.”