The market has become skittish, should the Federal Reserve abandon "data dependency"?

The Federal Reserve stated that it formulates policies based on received data, especially inflation and employment data. However, these data are both unreliable and fluctuate much more than usual, causing investors to jump back and forth in the fog. The data initially points to economic weakness, and then (sometimes after revisions) points to strength.

Since the Fed cut interest rates last month, economic data has been much stronger than expected. The soft employment data that prompted the Fed to cut rates by 50 basis points last month has reversed in this month's report, recording the third strongest reading this year. Real-time forecasts for third-quarter economic growth by the New York and Atlanta Feds both exceed 3%, higher than the 2% at the end of August.

Of course, the Fed should look at this data. However, relying on data means only looking at recent data and ignoring forecasts for the future economic impact of interest rates. Relying on data has led to unnecessary volatility in the bond market.

This summer, data indicated a slowdown in the job market, suggesting that high interest rates were hurting the economy. But now it seems that the economy is doing well, and inflation may be trickier than imagined.

The Citi Economic Surprise Index has returned above zero, indicating that economic data is better than expected.

Relying solely on the latest data can lead to short-term pessimism and trigger temporary prosperity, resulting in significant fluctuations in Fed rate expectations, which in turn affect the bond market.

Investors are chasing herd mentality rather than expressing collective wisdom. According to CME Fedwatch data, after the Fed cut rates by 50 basis points in September, the probability in the federal funds futures market of a further 175 basis points or more rate cut by the Fed by June next year surged to 77%.

Will there really be rate cuts equivalent to more than 25 basis points in the next six meetings? No. Traders now believe that the likelihood of the Fed making another significant rate cut during this period has returned to zero.

Traders' expectations of another significant rate cut by the Fed before June next year have been reduced to zero.

The Fed's data dependence exacerbates what psychologists call recency bias in the market (overestimating recent information and events), mistakenly believing that a few months of employment or inflation data represent significant changes in trends.

When the Fed is extremely concerned about inflation, relying on data makes sense. It is concerned that high inflation will spiral up in a self-fulfilling manner, affecting consumers and businesses' expectations of future inflation. To break this vicious cycle, the Fed raises rates, which will lead to recession forecasts and control price expectations. If reported price increases lead to future price increases through expectations, then focusing on reported price increases is reasonable.

When rates are stuck at zero, there is also a reason to rely on data. In the many years following the global financial crisis of 2007-09, the Fed has been trying to convince investors that rate hikes will be slow and action will be taken only after the economy starts to pick up. The goal is to lower long-term rates and prevent economic budding from being shattered by rapidly rising rate expectations A study by the Cleveland Fed found that this situation has changed in the inflation after the COVID-19 pandemic. The study found that rate futures traders are extremely sensitive to inflation data before each Fed meeting - this is true data dependence.

However, as the Fed tries to guide the economy to a soft landing, this reliance on short-term data becomes less meaningful. The Fed has the ability to study messy month-to-month data and focus on the big picture. The job market may still be hot, but it is no longer red-hot. Inflation remains above target, but it is no longer terrifying.

Apart from the data, the biggest issue is not how much further to lower the inflation rate, but how fast and to what extent to cut interest rates. This requires predicting the level of interest rates the economy can sustain in the long term.

Cynics are quite right to point out that the Fed's past forecasts have been terrible. Skeptics, including Wall Street Journal columnist James Mackintosh, have pointed out the wide divergence among Fed policymakers on where rates will ultimately settle.

Mackintosh believes that guiding a soft landing through the rearview mirror is not an option when rate changes take six months or longer to affect employment and inflation. It's time for the Fed to abandon "data dependence" and work to get investors to consider longer-term prospects.