Back to Stats 101
There is a statement getting a lot of repetition these days. It says something like "The Fed has only achieved X soft landings in the last Y years, so the odds are against them doing it this time." The repetition is making it part of the current conventional wisdom just like "Where’s the Beef?" became an expression that was known to all.
There was a typical rendition of this in a column on theStreet.com’s premium site this morning. The author is an earnest young man with an undergrad finance degree and some trading experience. I’m not going to name him, but his point is that a soft landing scenario is unlikely.
According to history, the odds are against that rosy scenario. When the
Fed has inverted the yield curve by more than 1/2 percent, taken the
discount rate above 6% (which began in May) and the spread between the
three-month bill is higher than the 10-year note, the Fed has induced a
recession 80% of the time. Most importantly, because the Fed is human,
it applies the logic and lessons of the last cycle to this cycle, even
though the economy has changed dramatically since the last cycle. For
example, they could have factored in that the current economy was much
more addicted to lower interest rates and globalization keeps inflation
lower and only raised rates to 4.5%. Yet they took rates from 1% to
5.25% and are now shocked Real rstate went into a tailspin so quickly.
Regular readers of "A Dash" should be able to spot the problems in this analysis:
- Since 1970, there have only been 7 tightening cycles prior to the current one. Even if you drag in results from the Great Depression as does Ned Davis Research, there are only fifteen.
- There have only been five recessions since 1970.
- Our writer uses three variables — yield curve inversion, level of rates, and something about the three-month and ten-year. The problem is referred to in statistics as degrees of freedom, and it comes very early in the course. Simply put, it means you need a lot more cases than you have variables.
When you see rules like this someone is back-fitting data, creating a perfect "explanation" of the past without any real predictive power. Speaking of "odds" in a situation like this makes no sense at all — but I hear it every day.
Astute readers might also notice the "I’m smarter than all of those Fed guys" implication of the last sentence. The inability or unwillingness to recognize and use the expertise of others is a prescription for failure.
Individual investors would do well to make sure that Fed critics are qualified to comment. It is a free country and everyone can have an opinion, but you need not listen!