Wednesday, July 23, 2014

Scenario Analysis & The Depressing Fed

I was reading Brealey, Myers and Allen on scenario analysis today, and was struck with a depressing thought. Scenario analysis, to clarify, looks at a limited number of combination of variables, and examines the effects of these various combinations on the net present value of a project or on firm enterprise value. This is an essential tool for any analyst. Perhaps my favourite quote on de facto scenario analysis comes from Bruce Kovner, who said "One of the jobs of a good trader is to imagine alternative scenarios. I try to form many different mental pictures of what the world should be like and wait for one of them to be confirmed. You keep trying them on one at a time." Kovner believed this was one of his competitive advantages: "I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine that soybean prices can double or that the dollar can fall to 100 yen."

I no doubt lack Kovner's creativity in imagining different macro scenarios, but I'm finding it desperately difficult to imagine a booming US economy. It seems very unlikely that the Fed wants to recover the lost NGDP gap from the Great Recession, and David Beckworth has highlighted evidence suggesting the Fed is targeting a corridor of 1-2% PCE growth. Expectations for growth, and to corporate earnings generally, must therefore be muted.

I'm not bearish by temperament, despite some cautious (some might say pessimistic) posts of late. I'm not predicting an imminent market correction, or suggesting that stocks are overvalued. I am inclined, however, to believe that a reasonable scenario analysis would assign a higher probability to a bear case than to a bull case.

Ryan Avent has also written an excellent post discussing the two-way interaction between Fed policy and the labour market, while Ambrose Evans-Pritchard believes Janet Yellen is less dovish than consensus perception. I'm reminded of the work of the sociologist Katherine Newman, which you can read in her books, or listen to on this superb EconTalk episode. Newman's ethnographic work recounts how marginal workers were brought into employment by the booming economy of the mid to late 1990s. As Marcus Nunes notes, this was the byproduct of the (accidental?) delivery of stable NGDP growth. Today, with low labour participation rates and the masses of the long-term unemployed growing, the Fed's determination to stave off any nascent inflation and secure financial stability (two separate, and possibly contradictory goals within the current framework) seems unnecessarily cautious. Try as I may to channel Kovner, it's hard to see anything but a negative skew to my scenario analysis.


  1. Ravi, unfortunately you may be right!

  2. I guess a key question is, can the US economy boom without the Fed changing course. If so, what are those ways. I don't claim to have the answers but I can't imagine that the only thing that will matter for growth is Fed policy, or that these policies are are so overwhelming as to make their outcome largely predictable.