Investors seem to be deceived by the Fed again. After the market incorrectly predicted seven times that policymakers would turn dovish, the Fed finally made a significant rate cut last month. However, now bond yields are rising sharply again and investors are reducing their expectations for the rate cut.

What's going on? The answer can be summarized in one word: data dependency.

The Fed says it formulates policies based on received data, especially inflation and employment data. But these data are neither reliable nor much more volatile than usual, causing investors to jump back and forth in the mist. The data initially points to economic weakness, then (sometimes after revisions) to strength.

Since the Fed's rate cut last month, economic data has been much stronger than expected. The soft job data that led the Fed to cut rates by 50 basis points last month has reversed in this month's report, recording the third strongest reading this year. Real-time forecasts for third-quarter economic growth from the New York and Atlanta Feds both exceeded 3%, higher than the 2% at the end of August.

Of course, the Fed should look at this data. However, relying on data means only looking at recent data and ignoring forecasts for the future economic impact of rates. Relying on data has led to unnecessary fluctuations in the bond market.

This summer, data indicated a slowdown in the job market, suggesting that high rates were damaging the economy. But now it seems that the economy is doing well, and inflation may be trickier than imagined.

Only with the latest data, it can lead to short-term pessimism and also trigger temporary prosperity, causing significant fluctuations in the Fed interest rate expectations, consequently impacting the bond market.

Investors are chasing herd mentality rather than expressing collective wisdom. According to CME Fedwatch data, after the Fed's 50 basis point rate cut in September, the Fed Fund futures market expects a surge in the probability of a further 175 basis point or larger rate cut by June next year to 77%.

Will there be rate cuts equivalent to more than 25 basis points in the next six meetings? No. Traders now believe the possibility of a significant rate cut by the Fed during this period has returned to zero.

The Fed's data dependence has exacerbated what psychologists call recent market distortions (i.e., overestimating recent information and events), mistakenly believing that a few months of employment or inflation data represent major trend changes.

When the Fed is extremely concerned about inflation, it makes sense to rely on data. It is worried that high inflation will spiral up in a self-fulfilling manner affecting consumers and businesses' future inflation expectations. To break this vicious cycle, the Fed raises interest rates, leading to recession forecasts and controlling price expectations. If reported price increases lead to future price increases through expectations, then paying attention to reported price increases is reasonable.

When interest rates remain at zero, there is also a reason to rely on data. In the many years following the global financial crisis of 2007-09, the Fed has always wanted investors to believe that rate hikes would be very gradual, taking action only after the economy begins to operate. The goal is to lower long-term rates and prevent the budding economy from being shattered by rapidly rising rate expectations.

A study by the Cleveland Fed found that this situation changed during the inflation after the COVID-19 pandemic. The study found that before each Fed meeting, interest rate futures traders were extremely sensitive to inflation data - this is true data dependence.

However, when the Fed attempts to guide a soft landing for the economy, this reliance on short-term data becomes less meaningful. The Fed has the ability to sift through monthly data noise and focus on the big picture. The labor market may still be hot, but it is no longer red-hot. Inflation remains above target, but it is no longer scary.

Setting aside the data, the biggest issue is not how much further inflation rates need to be reduced, but how quickly interest rates are cut and by how much. This requires forecasting the level of interest rates the economy can sustain long term.

Cynics are quite right to point out that the Fed's past forecasts have been very poor. Skeptics, including Wall Street Journal columnist James Mackintosh, have argued that there is widespread disagreement among Fed policymakers on where rates will ultimately settle.

Mackintosh believes that when rate changes take six months or longer to impact employment and inflation, guiding a soft landing through the rearview mirror is not an option. It's time for the Fed to abandon "data dependence" and work on getting investors to consider longer-term prospects.

Editor/ping