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The Fundamental Flaw in the Fed's Forward Guidance


The problem is not that the Fed is tapering.

It had been a while since the market had been provided any guidance from the Fed's de facto press secretary, the Wall Street Journal's Jon Hilsenrath, but late Friday he reemerged to provide his valuable insight. In Fed Officials Face Cliffhanger September Meeting After Mixed Jobs Report, he wrote:

Fed officials want to start scaling back their $85 billion-per-month bond-buying program this year and could take a small step in that direction at their policy meeting Sept. 17-18. But the economic data in recent months have been ambiguous and new threats to the economy and markets loom, which could prompt officials to wait longer before acting.

So they might taper and they might not. Thanks, Jon, you've been helpful. The market understandably didn't care about what are typically market-moving articles from Hilsenrath, but I took a different view. I thought his comments point to the fundamental flaw in the Fed's forward guidance communication strategy. Hilsenrath writes:

But in reality, officials have concluded over several months of market volatility that it matters immensely what signal investors take from their actions. They are deeply concerned that any move to scale back the bond-buying program will be seen wrongly in markets as a sign they're moving inexorably to end the program, a reaction that could push long-term interest rates up even more.

The Fed still thinks the markets are misunderstanding policy. Hilsenrath continues:
Most troubling to top Fed officials is the risk that investors will see a cut in bond purchases as a sign they'll start raising short-term interest rates, which have been pinned near zero since late 2008. The Fed has said short-term rates will stay low at least until the jobless rate falls to 6.5% and possibly much longer.

The Fed still thinks tapering is not tightening. Hilsenrath writes:
Fed officials see that commitment as a more powerful tool than the bond-buying program in their efforts to hold down long-term interest rates to encourage borrowing, spending, investing and growth and they want to reinforce it.

The Fed now thinks words speak louder than action.

The Fed is trying to better affect policy by being more transparent and increasing communication with the markets through more information flow. Here's the problem. The Fed tells the financial media how they want markets to behave and the media, in turn, reports market activity that is perceived to be a reaction to the Fed's guidance, for which the Fed, in turn, recalibrates the message to hone the guidance.

But what if the Fed is operating under a false assumption for how their policies, both QE and forward guidance, impact the bond market, and what if the media is incorrectly interpreting and reporting the market reaction? What if the information flow is incorrect? You will have a chaotic feedback loop between the Fed, the media, and the markets. Like we have now.

It is a widely held belief that QE impacts interest rates through two channels: the stock of bonds the Fed holds and the flow of the purchases. The Fed believes that it is the stock of bonds they hold that impacts interest rates. Ben Bernanke said it himself at his April 2012 FOMC press conference:
There's some disagreement, I think, about exactly how balance sheet actions by the Federal Reserve affect Treasury yields and other asset prices. The view that we have generally taken at the Fed in which I think -- for which I think the evidence is pretty good, is that it's the quantity of securities held by the Fed at a given time, rather than the new purchases -- the flow of new purchases, which is the primary determinant of interest rates. And if that theory is correct, then at such time that our purchases come to an end, there should be relatively minimal effects on interest rates at that time.

Well we now know this "theory" is not only incorrect, but has gone horribly wrong. The Fed didn't think tapering would equate to higher rates as long as their stock remained the same. The market had different ideas.

Readers of my articles know that I have been pounding the table that it is neither stock nor flow of QE that impacts interest rates; it is the inflation discount. QE raised the inflation discount in the curve and thus lowered real interest rates, finally pushing them negative and thus forcing nominal yields to record lows.

When the Fed backed off their commitment toward their stated inflation target by floating the tapering idea despite no inflation, the inflation premium collapsed and real rates blasted higher taking nominal rates with them. When interest rates began rising in May, TIPS breakeven spreads narrowed and the back of the curve flattened. This is not because of the stock of the Fed's holdings. It is a reduction in the inflation discount.
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