In his speech at the National Economists Club Annual Dinner last month, Federal Reserve Chairman Ben Bernanke offered the following thought:
“Making monetary policy is sometimes compared to driving a car, with policymakers pressing on the accelerator or the brakes, depending on whether the economy needs to be sped up or slowed down at that moment. That analogy is imperfect, however, for at least two reasons. First, the main effects of monetary policy actions on the economy are not felt immediately but instead play out over quarters or even years. Hence, unlike the driver of a car, monetary policymakers cannot simply respond to what lies immediately in front of them but must try to look well ahead -- admittedly, a difficult task. Second, the effects of monetary policy on the economy today depend importantly not only on current policy actions, but also on the public's expectations of how policy will evolve. The automotive analogy clearly breaks down here, for it is as if the current speed of the car depended on what the car itself expects the driver to do in the future.”
While I offered the gas-and-brakes analogy in Jim Bruce’s recent documentary on the Federal Reserve, Money for Nothing
, after spending the past several years studying confidence, I have a very strong appreciation for the nuance raised by Chairman Bernanke.
Whether we realize it or not, every action we take depends on what we expect will happen in the future. Our level of confidence drives our preferences, decisions, and actions, and confidence is entirely forward-looking. It is about how we feel right now about how we will fare in the future. When we say that we are confident now, we are really saying that we see ourselves doing well ahead. And it is that forward look that determines our choices now.
For an economy, current growth rates depend heavily on what investors, consumers, corporate executives, and so forth believe will happen in the future. Investment and spending decisions are tied to confidence.To paraphrase Chairman Bernanke, the current speed of the economy depends on what we expect to happen in the future, of which monetary-policy actions are a part. To believe the Chairman, the more certain investors are of what the Fed will do in the future, the more confident they can be in their decision-making today. Expectations matter.
While in theory this should be an easy thing for the Fed to manage, it isn’t. I believe that a big part of the challenge lies in causality, and the fact that the Fed, like most economists, has the connection between confidence and future actions reversed. It is not the certainty of future Fed policy that boosts our level of confidence, but rather it is boosted confidence that increases our perception of the certainty of future Fed policy actions.
Changes in our level of confidence distort our perceptions of certainty. When confidence is high, we overestimate the certainty of the future, including the perceived effectiveness of monetary-policy actions. Put slightly differently, the more confident we are, the more omnipotent we believe the Fed to be. What's more, the more confident we are, the further out into the future we extrapolate that omnipotence.
When we lack confidence, however, we believe the reverse. The less confident we are, the less confident we are in the Federal Reserve and the less effective we believe monetary policy will be.
Finally, I would also note that the Fed’s own internal dynamics are impacted by the public’s confidence in it. Like sports teams, high confidence leads to cohesiveness. When confidence is high, we believe that the Fed speaks with one voice. When confidence is low, however, we perceive the Fed’s message to be garbled. As you can appreciate, a multivoiced Fed challenges our perception of confidence in what the central bank is likely to do or not likely to do in the future, too. Confidence operates in virtuous and vicious cycles.
So, can our confidence in the Federal Reserve be measured?
I believe so. While this may seem like an unusual way to track confidence in the Federal Reserve, I believe that long-term interest rates are a great proxy. Looking at history, I believe that high long-term rates suggest a weak level of confidence in the Federal Reserve, while low rates suggest the reverse. When Paul Volcker took the reins of the Federal Reserve, interest rates were soaring, and in Congressional testimony at the time, he spoke openly about how the markets were frontrunning against
the Fed. Investors believed that the Fed (and Congress) would fail to curb inflation and regain control of the economy. (See chart here.)
In contrast, in the summer of 2012, we saw investors frontrunning with
the Fed in enormous size. Investors were so convinced that the Fed would adopt unlimited QE in the fall that markets bottomed months ahead of the action.
In July 2012, the Financial Times
reported the following:
“The US borrowed for 10 years at the lowest rate ever in Wednesday’s auction, (technically a reopening of an existing bond)…investors who were able to submit direct bids got their hands on a huge -- record -- amount of the total, around 45 per cent. The scale of demand at the auction suggests investors expect US interest rates to remain low for several years.”
I shared this quote along with the following thought with my clients:
“I realize that I am a very lonely with my belief that Treasury yields have bottomed, but whenever I see words like 'record,' clear investor extrapolation, and phrases like 'to remain low for several years,' the hair on the back of my neck goes up.
"At tops and bottoms in the market we believe that current conditions are permanent, and with regards to the US Treasury market, this feels like one of those moments.”
To me, the idea that the Fed could keep interest rates low for “several years” reflected a complete capitulation of investor influence on the bond markets. The markets believed that the Fed’s actions were certain and that the Fed was omnipotent, and investors then acted like it. The confidence was extreme.
Since last year, I have noticed that as interest rates have begun to creep up, investors have begun to doubt the effectiveness of Fed actions. More importantly, open dissent among Fed governors has arisen. The taper on/taper off experience from early this year has changed investors' outlooks on future policy actions. The future is far less certain that it was a year and a half ago.
As Chairman Bernanke said in November, the Fed believes that through transparency and forward guidance it can keep the short end of the curve anchored at zero for as long as the economy requires.
To me, that comes down entirely to a question of confidence. So long as investors believe that the Fed can keep the front end low, the Fed will be able to. Should the long end begin to rise, however, the Fed’s front-end anchor will be seriously challenged. Not only is it much more difficult to keep a very steep yield curve anchored to begin with, if that steepness is a function of declining confidence in the Federal Reserve, then the anchor is far less resilient in the first place. In a worst-case scenario, the entire yield curve could become untethered.
I've noticed a funny thing about transparency. During periods of rising confidence, we all adopt a don't-ask-don't-tell mindset. Investors don’t scrutinize and disclosure is kept to a minimum. As confidence falls, however, investors demand more information. Unfortunately, as the banking industry experienced during 2008, rather than satisfying investors' increased demands for disclosure, greater transparency actually raises more questions.
Having decided to adopt a more open dialog with investors -- particularly by a large group of independent-minded economist governors -- the Fed could easily find itself in a vicious cycle in which falling confidence and its resulting heightened demand for disclosure is accompanied by an openly divisive board with contradicting messages and outlooks.
To be clear, I don’t wish falling confidence on the Federal Reserve or any other group of policymakers; but Chairman Bernanke was very correct when he said, "the current speed of the car [depends] on what the car itself expects the driver to do in the future.” Confidence matters.
Over the past four years, stock and bond investors have increasingly ceded the driver’s seat to the Federal Reserve and other central banks. To believe investors today, not only does the Fed operate the gas and the brakes, but it firmly holds the wheel as well. With so many now on board, never before has the car put so much confidence in what the driver will do in the future.
Let’s hope the Fed maps out a very clear path as to what is ahead. Even more, let’s hope investors remain confident in the direction the Fed chooses to now pursue.
Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.
“Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the ‘me, here, and now’ behavioral tendencies of the post-crash world.” —Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation