20-Jan-23 Central banks

When it makes sense (not) to “fight the Fed”

Last year was unusual in market participants proving quite prescient in predicting U.S. interest rates. Paradoxically, that probably makes a repeat in 2023 less likely.

Compared to Fed officials, market participants proved unusually prescient in predicting U.S. interest rates throughout 2022


* for December 2022

Sources: RBloomberg Finance L.P., DWS Investment GmbH as of 1/16/23

For what it is worth, our own views are closer to the Fed’s. As Christian Scherrmann, U.S. economist at DWS points out, a strong labor market could even prompt the Fed to keep rates higher for longer. Beyond that, last year was rather unusual in market participants proving comparatively prescient. As countless empirical studies have shown over the years, futures markets have generally not been all that good at predicting Fed decisions, particularly those almost a year away, as opposed to a few weeks or months. “Also, errors tend to be relatively large when the funds rate changes direction or when it changes rapidly over a short period.”, as one early study, incidentally by a Fed economist puts it[1].

Or, as the old Wall Street adage has it, “Don't fight the Fed”. Like other mental rules of thumb – what we might call superstitions in other walks of life – that mantra has historically been correct sufficiently often to become conventional wisdom. After all, sudden monetary policy changes usually reflect new information that is, in general, at least as likely to catch markets by surprise as it is to wrong-foot monetary policymakers.

Occasionally, though, such mantras turn out to be wrong. That is when caution becomes particularly important. It is human nature to overestimate one’s judgment and underestimate randomness, especially when one has just had the good fortune to have been proven right. At least from the perspective of behavioral finance, the current self-confidence of many market participants may primarily reflect such recency bias. For that reason alone, the current collective wisdom looks unlikely to prove particularly well-grounded.

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1. Carlson, J.; McIntire, J.; Thomson, J. (1995) “Federal funds futures as an indicator of future monetary policy: A primer” in Economic Review - Federal Reserve Bank of Cleveland; Cleveland Vol. 31:1, pp. 24

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