The Fed vs. Financial Markets: A Clash of Economic Recovery Narratives

The Discrepancy in GDP Forecasts

Two distinct narratives about the post-pandemic economic recovery are emerging: one from the Federal Reserve and the other from financial markets. Market economists typically predict broader changes in quarter-over-quarter GDP than their counterparts at the Fed. However, the current discrepancy is wider than it has been in decades, leading to confusion in financial news. A recent edition of Squawk Box discussed how 'markets seem reluctant to believe the Fed's policy goals.'

Market vs. Fed Perspectives on GDP Growth

The markets see recent GDP growth as closely aligned to stock market performance, with a dramatic drop in the second quarter of 2020 followed by an equally dramatic recovery from third-quarter 2020 to third-quarter 2021. In contrast, the Fed views GDP as driven by structural economic considerations that move gradually from quarter to quarter, estimating a smaller drop in GDP for second-quarter 2020 and a slower recovery since then. Over the last year, the Fed's view has been proven right multiple times.

Economic Considerations Driving the Gap

The expectations gap between the Fed and market economists comes down to three economic considerations: fiscal stimulus and GDP growth, shifts in economic output, and timing. Market economists tend to assign larger multipliers to quantify the impact of government spending on GDP growth, expecting historically high GDP growth due to the high fiscal stimulus of the last 12 months. They also tend to weight quarterly data differently, leading to overestimations in activity changes during the COVID-19 economy. While both the Fed and markets agree broadly about GDP growth, they disagree on timing, with market economists allocating most of the growth to 2021 and the Fed spreading it over the 2021-2023 period.

For readers, it's crucial to understand these differing perspectives when making investment decisions. Stay informed about both the Fed's and market economists' forecasts to better navigate the economic landscape.