Questions over forward guidance
Fed needs to express itself better – and markets need to listen better
by Gabriel Stein in London
Tue 24 Sep 2013
Last week it briefly seemed as if we were back in the world of the 1980s, when central banks delighted in surprising markets with their actions (or inactions).
Nearly everybody agreed that the Federal Open Market Committee (FOMC) would announce some form of taper of its quantitative easing (QE), possibly combined with new explanations of how its future policy would work. Nearly everybody got it wrong. Given the Fed’s emphasis on forward guidance – i.e. on preparing markets for its actions – this was clearly not the greatest triumph of central bank communication.
Was this a failure of forward guidance? Yes – and no. If it was a failure, then the responsibility lies on both sides, with both the guide and the guided.
The Fed began to talk about tapering in the late spring. Chairman Ben Bernanke said that the FOMC was likely to begin its taper later this year and that he expected QE to have run its course when the rate of unemployment dropped below 7%. He did stress, as have other FOMC members, that the policy is data-dependent.
This is where forward guidance first failed. The guided – markets and others – listened to what was being said and – not unnaturally – thought that such explicit guidance meant that it was a done deal. They reacted by selling off bonds. Yields on US Treasuries rose by around one percentage point. The failure of the guided was to not listen carefully enough to what the various Fed spokesmen were saying in the meantime. Instead, the conviction grew that the QE taper would now begin.
However, there was also failure on behalf of the guide – the Federal Reserve. This is more serious and on multiple levels. One reason that the Fed did nothing was apparently because it was concerned about higher bond yields and did not want to do anything that would push them up even further. But surely FOMC members must have known that any taper talk would lead to a bond sell-off. More importantly, over the summer no one from the Fed said, ‘The economy has been much weaker than we expected; we need to postpone the start of the taper.’
It was repeated that policy was data-dependent – but data has not been that bad. Unemployment continued to fall. We must note that Bernanke at his post-FOMC meeting press conference explicitly ruled out the lower participation rate as a main cause of lower unemployment. Second quarter GDP came in stronger than originally forecasted.
Labour market and housing data weakened slightly. But if the Fed is going to be spooked by one or two months’ worth of data, then it will never be able to end QE.
All this is in the past. In future, the Fed needs to express itself better – and markets need to listen better. The art of scrutinising Fed statements will become even more advanced. Every word will be significant. Yet there is still room for surprises. Most commentators have concluded that it is unlikely that the Fed will now begin to taper in October, since this would – presumably – play havoc with its credibility (June: taper; September: no taper; October: taper).
Possibly – but Bernanke made it clear that he believes the taper can still begin in 2013. At least one regional Fed president, Jim Bullard from the St. Louis Fed (well known to OMFIF audiences), has said that October may be the month to begin.
It is noteworthy that Bernanke discussed the possibility of an inflation trigger – a rate of inflation below which the Fed would not raise interest rates. In one sense, this is a further helpful guide to markets. In another, it further complicates forward guidance. The Fed is attempting to be clear and transparent. But, in doing so, it risks creating further volatility and uncertainty. From this perspective, it might have been better to announce a small taper and then get on with it.
Prof. Gabriel Stein is OMFIF’s Chief Economic Adviser.
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