We can get the October FOMC preview out of the way early:
No data + fiscal turmoil = no taper.
No reason to waste much time on the October meeting. Probably true for December as well at this rate. What is still worth spending time on is diagnosing the challenges of the Fed’s communication strategy. Sooner or later, that problem will rear its ugly head again.
To help narrow the field, I am going to propose four central problems complicating the Fed’s communication strategy:
1.) Unemployment targets. The unemployment rate revealed itself to be a poor choice of a policy variable for two reasons. First, it was the only data for which their forecasts turned out to be too pessimistic. Second, they don’t completely understand the dynamics that resulted in overly pessimistic forecasts. Was the rapid drop in unemployment structural or cyclical? Unknown, but they still attached it to not one but two policy shifts; the 6.5% threshold for considering hiking interest rates, and the 7.0% trigger for ending asset purchases. At this point, both numbers are irrelevant, but while Federal Reserve Chairman Ben Bernanke has backed away from the 7% QE trigger the 6.5% threshold remains in the FOMC statement. My suspicion is that they would like to get rid of it, but don’t know how. In short, the unemployment targets made the Fed’s reaction curve appear more hawkish than actual FOMC policy.
2.) Lack of experience with unconventional tools. Federal Reserve Governor Jeremy Stein’s recent speech is a must read for insights into the transmission of monetary policy. Not just once, but two or three times. Importantly:
Again, the existence of this recruitment channel is helpful; without it, I suspect that our policies would have considerably less potency and, therefore, less ability to provide needed support to the real economy. At the same time, an understanding of this channel highlights the uncertainties that inevitably accompany it. If the Fed’s control of long-term rates depends in substantial part on the induced buying and selling behavior of other investors, our grip on the steering wheel is not as tight as it otherwise might be. Even if we make only small changes to the policy parameters that we control directly, long-term rates can be substantially more volatile. And if we push the recruits very hard–as we arguably have over the past year or so–it is probably more likely that we are going to see a change in their behavior and hence a sharp movement in rates at some point. Thus, if it is a goal of policy to push term premiums far down into negative territory, one should be prepared to accept that this approach may bring with it an elevated conditional volatility of rates and spreads.
The Federal Reserve is playing with a tool they don’t completely understand. I believe they thought that by introducing the notion of tapering in the spring and summer they could minimize bond market volatility. This was effectively an effort to avoid a recurrence of the jump in rates experienced in 1994. Obviously, things did not go according to plan – yields jumped, taking mortgage rates with them. The outcome was a more severe monetary tightening than intended. An ill-timed tightening at that, given that expectations of fiscal relief were only tentative to begin with and may have been dashed by the budget showdown. Simply put, their inexperience with unconventional tools led them to pull the trigger on tapering talk far too early.
3.) Fine tuning. The Federal Reserve appears to believe they can fine tune the asset purchase program with small changes up or down. This seems silly given point two above – you can’t fine tune something you don’t understand. Just talking about tapering was 100bp+. So who knows what a mere “$10 billion” means? And what is the threshold for small changes? Do we need significant shifts in data, or is being “broadly consistent” with the Fed’s forecast sufficient? This point was driven home today by Boston Federal Reserve President Eric Rosengren:
All this means that our fundamental reliance on data in policymaking may result at times in less signaling, before FOMC meetings, about small changes in the purchase program.
Translation: If this was a big change in policy, it would be obvious. But with a small change, who knows? Don’t expect much from Fedspeak when we are fine tuning. The problem is that fine tuning might have big impacts, so adequate communication is still important.
4.) Lack of a central voice. I think that the lack of a central voice for monetary policy is a critical failure at the moment. Here I am going to fall back on Rosengren:
I would add that interpreting the data is an important and nuanced matter. The FOMC is a committee, and different participants can and often do have different perspectives on the strength of the incoming data. Some of the indicators the committee must weigh in preparation for policy meetings include data that provide only partial information on an aspect of the economy – so that their import only becomes clear once we have the fuller context provided by other, related data. Also, importantly, assembling a coherent picture of the overall economy is challenging even with complete data, and involves “art” as well as science.
This is not good – the implication is that we cannot rely on individual speakers as policy guides. And possibly worse yet, they know this. How does that influence their own communication strategy? I often wonder if they are using speeches less to signal their opinions to the public, but instead more to signal their position to other FOMC participants. I also wonder if they are unwilling to take a public position for fear of being “wrong” at the conclusion of the next FOMC meeting. Consequently, you get odd communication such as St. Louis Federal Reserve President James Bullard claiming that tapering is possible in October, when such an expectation was completely unrealistic even before the federal shutdown. There is no way that just six weeks from the last meeting you could be confident that the impacts of earlier fiscal tightening had waned sufficiently to justify tapering. So does he really believe that tapering is possible, or does he not know the direction of policy any better than any other public speaker, so he is thus willing to give anything but “who knows?” And you might not know given that we are only talking about “tiny tapers.”
Much of these issues could be eliminated if their was a core group of governors that we could look toward as the basis of a policy baseline. But no such core exists. Bernanke could fill that role, but here I think his desire to treat the FOMC as a university economics department is a disservice to the communications strategy. It is fine if to allow everyone their own opinion behind the scenes, but a central position in public would be helpful, especially given the desire to try to fine tune policy. Bernanke, however, appears to have checked out already, not wanting to provide any of his own benchmarks, perhaps because his days are numbered. Alternatively, Vice Chair Janet Yellen could fill this role, but she disappeared from the public eye in the run up to the race to succeed Bernanke. And we will not hear from her until she is both nominated and confirmed, and realistically that might not occur until next year. So the transition process has robbed us of what is believed to be a critical voice within the FOMC at exactly the time monetary policymakers are contemplating a policy shift. Bad timing, to say the least.
Bottom Line: There is much room room for improvement with the Fed’s communication strategy. They might want to get on this given their increasing reliance on forward guidance.