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The Fundamental Flaw in the Fed's Forward Guidance


The problem is not that the Fed is tapering.

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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