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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.

The Fed didn't really announce this with an FOMC decision, but sometime in the spring they completely changed their policy from a focus on QE to what is now deemed forward guidance, a.k.a. Jedi mind tricks. Back on June 15 in US Monetary Policy at a Crossroads, I discussed this concept after Bernanke had dropped the hint in a speech he gave to the NBER:
The framework for implementing monetary policy has evolved further in recent years, reflecting both advances in economic thinking and a changing policy environment. Notably, following ideas of Lars Svensson and others, the FOMC has moved toward a framework that ties policy setting more directly to the economic outlook, a so-called forecast-based approach.

In 2003 Svensson wrote a working paper for the NBER titled Escaping From a Liquidity Trap and Deflation: The Foolproof Way and Others:

Thus, even if the nominal interest rate is constant at zero, the central bank can affect the real interest rate, if it can affect private-sector inflation expectations. If the central bank could manipulate private-sector beliefs, it would make the private sector believe in the future inflation, the real interest rate would fall, and the economy would soon emerge from recession and deflation.

It sounds good on paper, but the Jedi mind tricks aren't going to cut it and the market has spoken. Despite the emphasis on forward guidance, once the market sensed the balance sheet would no longer be expanding to effect inflation expectations, it began removing the inflation premium. However the Fed sees the reaction to tapering as a vote of no confidence in their commitment to holding the Fed funds rate at zero until economic thresholds are met. This is an incorrect interpretation for what happened, and both the Fed and the media don't seem to get it.

The Fed and the financial media see interest rates (the 10-year yield) rocketing higher and just assumes the market thinks the Fed is going to start raising interest rates. The Fed and the financial media think the curve is a function of future Fed funds expectations (plus a term premium). The media tells the Fed the market thinks Fed funds is going higher and the Fed tells the media this is a misinterpretation of policy intentions. They are both wrong.

Yield Curve Interest Rate Risk Vs. Inflation Risk

The policy shift from QE to forward guidance has seen two dramatic but very different shifts in the yield curve discount. The market isn't pricing in higher Fed funds per se, the market is pricing a higher interest rate risk premium in the front end (2-year/5-year, eurodollar strip) and in tighter monetary conditions due to the lack of QE in the long end (10-year/30-year, breakevens). The market is raising the interest rate risk premium by steepening the front of the curve due to the uncertainty of forward guidance (and Larry Summers) moving toward a worst case scenario for Fed funds rate hikes. The market is lowering the inflation discount by flattening the back of the curve because tapering and an eventual exit from QE means the days of excess dollar liquidity are over.

The Fed sees this curve dislocation and thinks they need to strengthen forward guidance, so they call Hilsenrath on the bat phone to try and talk the market back down, trying to convince participants they are concerned about rates rising too fast. Hilsenrath reports that the Fed might taper or they might not or they might lower the economic thresholds or commit to zero Fed funds for longer. The market hears this loud and clear and is pricing the curve accordingly. There is nothing unusual to what is happening in the bond market. The curve is rationally discounting what has become monetary policy chaos.

The problem is not that the Fed is tapering. The problem is the Fed is trying to calibrate policy based on a market discount they misinterpret through communication they misunderstand. The problem is policy chaos. It's become obvious the Fed doesn't really understand how the market works. First the Fed erred in relying on the stock theory of QE, and now they are basing forward guidance on a misunderstanding of the yield curve discount. As a result, leveraged investors across global capital markets are delevering en masse and liquidity is tightening rapidly.

This policy shift was, in theory, designed to increase transparency and decrease volatility, but the opposite has occurred because Fed policy is based on a fundamental flaw. We don't need stronger guidance or the market to have confidence in the Fed. We need less guidance and for the Fed to have confidence in the market.

Twitter: @exantefactor
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