The reason Wall Street and the US Fed failed in their inflation forecasts

Almost everyone on Wall Street and in Washington was wrong in predicting 2022. The Federal Reserve expected the rise in inflation in 2021 to be temporary, which it was not. Core inflation climbed to a 40-year high in the fall, nearly three times the Fed’s full-year forecast.

Leading analysts on Wall Street expected the markets to have a so-so year, not what it was. Now, with only a few trading days left in the year, the S&P 500 is down 19% and is expected to post its biggest annual loss since the financial crisis of 2008. Bonds are expected to post their worst year ever.

The magnitude of the error on the part of investors, analysts and economists has left many wondering what next year will look like. The big discussions about 2023 have already begun: the Fed has hinted that it intends to continue raising interest rates, yet traders are pricing in interest rate cuts. Corporate executives are raising red flags about a possible recession, but economists at some banks, including Goldman Sachs and Credit Suisse, say the U.S. economy will avoid a slowdown in 2023.

“We approach 2023 with a certain degree of humility”

Some investors and analysts say that if there is a lesson that can be learned from the last 12 months, it is this: prepare for more surprises.

“We all approach the year ahead with a certain degree of humility,” says Christopher Smart, chief global strategist and chairman of the Barings Investment Institute.

Like many other strategists, Smart expected inflation to moderate in 2022. But he didn’t expect Russia to invade Ukraine, causing oil prices and energy stocks to briefly soar. He also did not foresee how long China would stick to the zero-coronavirus policy, which has extended supply chain problems for companies around the world.

“You can always say in retrospect, we knew there were those risks. But everyone thought they were unlikely going into the new year,” Smart said.

So what is unlikely next year to tell Wall Street? Currently it seems that this is another increase in inflation. About 90% of investors expect global inflation to decline in the next 12 months, according to a December survey of fund managers conducted by Bank of America. This is the largest number of people who think so in the history of the survey.

The growing confidence that inflation may have already peaked has many investors betting on a reversal in market trends in 2023. Fund managers reported holding larger-than-average holdings of bonds in their portfolios for the first time since 2009, according to the survey. In other words, many investors are counting on a drop in inflation to turn this year’s losers – bonds – into next year’s big winners.

“I think if you’re a betting person, you have to conclude from the data that inflation is going down,” said Nancy Tengler, chief investment officer at Laffer Tengler Investments.

Fed Chairman Jerome Powell has said it is too early to conclude that inflation has peaked. But Tengler and others cast doubt on that.

Prices for everything from airline tickets to used cars and package deliveries have dropped in recent months, Tengler said. This helped consumers to be more optimistic about the outlook for the economy. Data from Wednesday showed that consumers’ expectations of inflation in the coming year fell in December to the lowest level in a year, while their confidence level rose to an eight-month high.

“Inflation will surprise many with its decline”

Bond traders have noticed this. One of the signs that many believe that the Fed does not have much room left to raise interest rates is the yield on two-year bonds, which stood at 4.321% on Friday, a significant increase on an annualized basis but a drop of more than a third of a percent compared to the record that was in November .

Yields on relatively short-term bonds tend to follow traders’ expectations about monetary policy – they rise when traders expect the Fed to raise interest rates and fall when they expect the Fed to stop raising interest rates or start cutting them back.

“It didn’t go down in a straight line, but I do think that inflation will surprise many with its decline,” said Tengler, whose company has been investing more money in risk assets, such as stocks, in recent months.

Others remained unconvinced. The sharp changes last year made them question what the Fed says will happen. If anything, according to them, it pays for them to question what has become a general consensus among investors.

Fund managers who participated in the Bank of America survey say that high inflation is the most important “tail risk” for the markets, followed by a deep global recession and tightening monetary policy by central banks. In the language of the market, tail risk is an extremely negative event, the chances of its occurrence are small.

“The market continued to believe that any rate hike was probably one of the last, even though the Fed kept telling the markets that it wasn’t,” said Scott Collier, CEO of Advisors Asset Management. “I think if you fight against the Fed, you take that risk on yourself “.

By Editor

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