“The Output Gap Appears Closed” – The Fed’s Model Just Confirmed A December Rate Hike

Back on July 24, as we first wrote then, the 2 Year bond yield suddenly tumbled just before noon…

… when it was discovered that “accidentally” the Fed released its confidential, policy-driving economic projections, alongside its public forecasts, as calculated by the Federal Reserve’s FRB/US computer model.

These were far more dovish than most, at the time, expected and certainly far worse than the Fed’s public computer model data indicated. To wit: “While superficially, and as expected, the Fed is assuming a 1.26% fed funds rate in one year, suggesting about 3-4 rate hikes until then, with the first one according to the leaked documents taking place in Q3, the overall strength of the economy is well weaker, and thus more dovish, than many of the permabulls had expected.”

This led to a sharp repricing of both short-term rates and inflation expectations. Four months later we find that, at least one, the Fed’s model was right, ironically this happened when it had predicted a slowdown.

As a we first wrote then, approximately every three months, Federal Reserve Board staff update and publish on the Board’s website a package of computer code of the Board staff’s FRB/US model of the U.S. economy, including a set of illustrative economic projections based only on publicly available information.

On June 29, an updated package of code was posted that inadvertently included three files containing staff economic forecasts that are confidential FOMC information. Two files contained charts of the staff’s projections for economic variables such as the unemployment rate, the core inflation rate, and gross domestic product growth as well as the staff’s assumption for the path of the federal funds rate target selected by the FOMC. Another file contained computer code used to generate a table displaying staff economic projections.

Three months after the July 24th fiasco, this Friday afternoon the Fed released an updated set of FRB/US outputs which this time may have precipitated the late day selloff as the results showed a vastly different picture than the one revealed in July. The model also may explain the unexpectedly hawkish tone in the Fed’s October statement.

In short: the model validated concerns that the Fed may hike rates in December because the Fed’s take, at least as modeled under Excel, is that the“slack in the US economy has substantively disappeared.” This is shown in the chart below which shows the dramatic divergence between the last and most recent FRB/US forecast on the US output gap.