By James Mackintosh 

It is time to think about Fed mistakes.

New Federal Reserve Chairman Jerome Powell set out his thinking to Congress at the start of this month: a tight jobs market, strong economic data, expansion around the world and President Donald Trump's tax cuts all supported the idea that, as fellow Fed governor Lael Brainard put it, headwinds have shifted to tailwinds.

The first three reasons have all been questioned since Mr. Powell and Ms. Brainard spoke. Could the Fed's turn to higher rates be a miscalculation?

I continue to think the Fed would be right to tighten, and raise rates more this year than the three times priced as most likely by futures markets. But I'm less sure than I was, and investors are right to be a bit more cautious. A mistaken extra rate rise or two probably wouldn't register as the kind of epic Fed error that causes a recession, but if the Fed gets it wrong and has to reverse course, a lot of investors who have bet on rising rates would lose out.

The Fed could be mistaken in two ways. The economy might be less strong than central bankers think, or it might be strong but create less inflation. Evidence for both views has been coming through this month.

Start with the latest payroll figures, published a week after Mr. Powell's testimony. The data were robust, with 313,000 new jobs created. But they also showed that the strong jobs market was encouraging more people to look for jobs -- with the civilian labor force increasing by 806,000. More people trying to find a job should damp wage pressures and mean less need for rate increases. If this pattern is a mark of things to come, it means the "Goldilocks" economy -- not too hot, not too cold -- can continue, putting a lid on bond yields.

The U.S. economy is sending mixed messages, though. Lots of jobs were created, but surprisingly weak retail sales and housing reports have prompted economists to downgrade forecasts for first-quarter GDP growth. When Mr. Powell gave his optimistic outlook to Congress, the Atlanta Fed's "nowcast" of first-quarter GDP was running above 3% annualized. It is now just 1.8%, having briefly been above 5% in January.

A broader model run by the New York Fed is more positive, at 2.73%, but also the weakest it has been this year, down from 3.45% in January.

Jan Hatzius, chief economist at Goldman Sachs, says a weak first-quarter GDP number wouldn't be too troubling. There are longstanding issues with seasonal adjustment in the first quarter, and he thinks recent efforts haven't fully resolved the tendency of the figures to be depressed compared with the rest of the year. More important, other measures that aren't used in GDP calculations, such as industrial and small-business surveys and job figures, have been far stronger.

"People put a lot of weight on GDP, and often too much," he says. "I don't think it's the be-all-and-end-all of economic indicators."

Still, the synchronized global growth that made everyone so positive earlier this year is showing signs of strain. Economic data have been coming in well below forecasts in the eurozone, with industrial production and inflation disappointing, and the "soft" survey data also worse than expected. It is no catastrophe, but forecasters were too optimistic about the pace of improvement.

A similar message is coming from the commodity markets. Industrial metals prices have fallen this year, after a big run-up last year, supporting the idea that investors were overoptimistic about economic growth and global demand.

None of this is likely to bother the Fed too much, especially with tax cuts in place and bigger budget deficits on the way. Traders are pricing a 94% chance of a 0.25 percentage-point rate rise at its meeting on Wednesday. The core prediction remains three rises this year, but traders see the Fed's hawkish tilt and the probability of four or more increases reached 36% on Friday for the first time, according to CME Group.

Bond investors are more cautious, with the 10-year U.S. Treasury yield briefly dipping below 2.8% on Wednesday, down from 2.96% in February. The big bets on rising yields would go badly awry if the U.S. and global economies are indeed slowing, and the Fed has to reverse course, or if a bigger workforce brings less wage pressure.

These issues are probably just temporary. But at a time when investors are trying to decide whether the economy is shifting to a phase of faster growth and whether it could be sustained or lead to recession in a year or two, they add unwelcome confusion.

Write to James Mackintosh at James.Mackintosh@wsj.com

(END) Dow Jones Newswires

March 19, 2018 11:31 ET (15:31 GMT)

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