The Commitment Phobic Fed

Stock market investors have long understood that company guidance can be a double edged sword.  Investors use company guidance to make inferences about trading conditions and the level of conviction that insiders have about their own growth prospects.  But in periods of low earnings visibility, the supply of guidance shrinks at precisely the time that the demand for guidance from investors grows.  During the financial crisis for instance, many listed companies sought to manage their reputational risk by ceasing to give guidance to the market.

Central banks of course don’t have the luxury of ceasing communications to the market when macroeconomic uncertainty increases.  In fact, they should (and most do) talk more during such periods.  In his pioneering paper presented to the 2012 Jackson Hole symposium, Professor Michael Woodford argues that what central bank speak reveals about the bank’s policy reaction function has greater market impact than what the bank says about the economic outlook.  After all, investors can form their own views about the outlook based on alternative sources of information, notably the flow of economic data.

Central bank speak has taken on a new meaning for many central banks in recent years given the unprecedented nature of quantitative easing.  The volatile market reactions in recent months to the Fed’s mixed messages on the likely timing of tapering illustrates the perils of interpreting central bank speak.  The past week was no exception.

The fundamental problem that the Fed faces is that animal spirits remain dormant in the business and housing sector and this continues to weigh on the broader US recovery.  Despite the profit share of GDP being at a record high, corporate gearing remains low, firms continue to hoard cash, real business investment remains marginally below the peak from five years ago and businesses remain reluctant to hire new workers; the hiring rate of 3.2% remains close to historical lows.

Although the flow of residential investment has grown by one-third since 2010, it remains almost 50% below its 2006 peak.  Inflation expectations remain well anchored and various measures point to still substantial slack in the labour market: the employment to population ratio has barely recovered since the financial crisis, the unemployment rate remains above 7% and the participation rate continues to decline to its lowest level in over thirty years.

Given that the Fed Funds rate hit the zero lower bound a number of years ago, the Fed has used the two remaining levers available to it: quantitative easing and forward guidance on the Fed Funds rate.  In so doing, the Fed is seeking to revive animal spirits through the wealth effect – via higher asset prices – and by reducing the level of long term Treasury yields and mortgage rates.

What is crucial to the Fed’s task is using central bank speak to influence and manage investors’ expectations.  But this is turning out to be more difficult than the Fed had probably envisaged.  Woodford argues that the zero lower bound does not render monetary policy impotent, but that effective forward interest rate guidance can influence agents’ expectations of the term structure.  If the central bank can convince economic agents that it will keep interest rates close to zero for an extended period, then it will be more effective in bringing forward agents’ decisions to spend and invest, and in so doing, revive animal spirits.

The problem that the Fed faces relates to its reputation, credibility and commitment; how to credibly convince the market that it is going to commit to a certain course of action in the future.  Skeptikoi’s interpretation of Woodford’s thesis on forward interest rate guidance is that it is best achieved on a calendarised basis; the central bank commits to not raising the operating interest rate for a fixed period, with a clause giving the bank the flexibility to lengthen the amount of time if necessary (but not shorten it).  The market will be sceptical of a central bank’s commitment to keep rates low for an extended period if they believe that the bank will take away the punch bowl just as the recovery is taking hold.  Calendarised forward guidance is credible precisely because it locks central bank into a pre-determined course of action, thus denying the central bank the flexibility to tighten policy during this period.

But Fed speak suggests that it wants to have its cake and eat it too.  Rather than use calendarised forward guidance, it has adopted conditional forward guidance; the interest rate will remain close to zero until (deliberately ambiguous) thresholds relating to unemployment and inflation are hit.  Data dependent forward guidance allows the Fed to retain a fair degree of policy discretion and flexibility to change its course of action.  This represents an important trade-off for the Fed to manage between policy flexibility and committing to a certain course of action in the future.  But the Fed’s desire to retain policy flexibility undermines the efficacy of its forward guidance.  No wonder that markets are confused and frustrated by Fed speak.

Interestingly, the Fed’s decision to defer the tapering of its quantitative easing program demonstrates the central bank’s willingness to sacrifice some policy flexibility for credibility of a different kind.  The decision to defer speaks to the recent rise in uncertainty surrounding the outlook and the Fed’s determination to manage its reputational risk.  Rightly or wrongly, the Fed believes its credibility as a forecaster would be undermined if it needs to re-initiate QE after a decision to taper has been made.  But prior to its recent downgrade to its economic projections, its GDP growth forecasts of 2.45% and 3.25% for 2013 and 2014 respectively, sat well above consensus estimates.

Fed speak suggests that the central bank appears to be more concerned about managing its reputation as an economic forecaster than its credibility to committing to a future course of action of keeping the Fed Funds rate low for an extended period.  But Skeptikoi believes that the Fed’s credibility on forward rate guidance is more important to sustaining the recovery than its own track record as a forecaster.  To re-visit Woodford’s thesis, markets pay more attention to communications that reveal information about a central bank's policy reaction function than its views on the outlook.  

Skeptikoi can only speculate that the Fed’s commitment phobia on forward rate guidance stems from an aversion to inflation that has its antecedents in the spectre of the Great Inflation of the 1970s, a time in which many of the senior members of the Federal Reserve were in the formative (and impressionable) years of their economics training.  The Federal Reserve will continue to be confounded by the market’s reaction to its communications and markets will continue to be frustrated by a lack of clarity in Fed speak as long as the Fed's commitment phobia on forward rate guidance persists.