From goldilocks to red riding hood

A few years ago, the ‘goldilocks’ narrative was particularly popular among macro investors: belief in an economy that was neither too hot, nor too cold, to unsettle markets. Recently, that has been replaced with the ‘narrow path’ analogy which suggests that equilibrium it is getting increasingly hard to sustain.

The chart below is, hopefully, a good way of making the point. Before every policy meeting, the New York Federal Reserve conducts their Survey of Market Participants (SMP). They ask 28 of the largest institutional investors a range of questions about the outlook. It’s interesting because investors are asked to outline the range of possible outcomes they see, rather than just the single most likely scenario.

We’ve long been fans of thinking about distributions rather than point estimates. The chart reveals that investors seem bizarrely confident that US inflation will fall into the ‘goldilocks’ zone in the next two years: the chance of inflation falling into the 1.5-3.0% range is seen as nearly 90%. Since the early 1960s, that has only been the case 35% of the time. Since 1987, often identified as the start of the ‘great moderation’ in economic data, that has only been true 50% of the time.

It's clearly possible that inflation falls within the moderate range both this year and next year. It might even be likely. But in our view, to believe there is only a one-in-ten chance of a more extreme outcomes is to ignore the evidence of economic history.

Maybe we should switch from talking about the ‘goldilocks economy’ to talking about the ‘red riding hood economy’. It’s currently skipping along a path through the woods, but the big bad wolf of inflation volatility lurks in the darkness if it strays too far from the straight and narrow.