There's one key reason the Fed has been too optimistic for more than a decade
Lael Brainard, a prominent member of the Fed's board of governors made the following admission in a recent speech, highlighting what policymakers see as an economic puzzle: "At a time when the unemployment rate has fallen from 8.2% to 4.4%, core inflation has undershot our 2 % target for 58 straight months."
So why is the Fed raising interest rates rather than cutting them?
That's what Brad DeLong, a University of California, Berkeley professor and former US Treasury official, is wondering himself. Low inflation may seem like a good thing, but when it's persistent and pervasive it points to a job market that is operating well below its full potential and where wages are largely stagnant.
In a rather excoriating piece for Project Syndicate, DeLong takes the Fed to task for being consistently overoptimistic about the economy's prospects, and thus their ability to begin raising interest rates.
"The Fed has now overestimated the strength of the US economy for 11 consecutive years," DeLong writes. "Elementary mathematics dictates that credible forecasts should at least overestimate half the time and undershoot half the time. If each year of Fed forecasting were a coin toss, we would now have had eleven heads in a row, and zero tails. The odds of that happening are one in 2,048."
There's a key reason for the Fed's undue optimism: It is not only the economy's steward, but has also taken on the uncomfortable and dangerous role of cheerleader. This may help maintain confidence in the short-run, but is costly to the central bank's credibility in the long run.
Surely, those members of the Fed who, like Brainard, are considered dovish and therefore would like to see the job market improve as much as possible, must be reconsidering? Not quite yet, she said in the speech.
"If the tension between the progress on employment and the lack of progress on inflation persists, it may lead me to reassess the expected path of the federal funds rate in the future, although it is premature to make that call today," she told the New York Association for Business Economics on May 30.
DeLong thinks the Fed is far too complacent about risks to a still-fragile economy.
"Today's weak inflation outlook suggests that the Fed's monetary policies, in combination with fiscal policies, are not providing sufficient stimulus for the US economy," he writes. "Unfortunately, the FOMC does not appear to be particularly concerned about this possibility."
Albert Edwards, strategist at Societe Generale, is equally flummoxed: "It is incredible to think that this US recovery, the third longest in history, has seen core PCE barely exceed its 2% target and for only three months in 2012. That shows how deeply entrenched deflationary pressures are."
And here's the kicker, Fed: "Inflation has likely peaked at yet another lower low in this cycle," Edwards wrote.
