The Federal Reserve has a PR problem.
In an attempt to curb excessive inflation, the Fed has attempted to signal investors and financial markets its plans to combat rapid price growth. For monetary policy and rate hikes to work, markets need to clearly understand the Fed’s goals and stick to those goals. But recent communications from Chair Jerome Powell and other Fed officials have been confusing at best — and you only have to look at the market’s sizeable moves over the summer to see missteps being made.
This is not just a problem for Powell and the Fed, but for the economy. When investors stop listening to the Federal Reserve, even perfect decision-making by the Federal Open Market Committee — the Fed’s main rate-setting committee — can result in a tragic misstep that’s either too restrictive or too dovish. In order to actually achieve the desired level of tightening and lower inflation without losing control of the process, the Federal Reserve needs to streamline its communications with markets.
Play the expectation game
Markets are inherently forward-looking, anticipating a company’s future or next few years of economic growth. In order to move the economy towards the desired outcome, the Fed uses this forward-looking nature by steering financial terms. As economic conditions change, markets consider what the Fed and other central banks will do next. By signaling future rate cuts, the Fed hopes to send a signal that will prompt companies to stop and invest while households spend more – which will stimulate the economy. By signaling that rate hikes are imminent, the Fed hopes to slow asset price growth and weaken confidence by cutting consumer and corporate spending.
Using financial conditions to modulate the economy has proven extremely useful for the Fed in the past. After the global financial crisis, interest rates were already at zero, which allowed the Fed to stimulate the economy even further. One solution was to wire the intention to keep interest rates low until the economy was put on a more stable footing, a so-called strategy forward guidance. Forward guidance meant markets could price in low interest rates well into the future, which helped keep the stock market strong and mortgage rates low even though the Fed was unable to cut rates further.
In other cases, this signaling has not gone so well. In fact, when the Fed began raising interest rates in 2004, the private sector’s cost of debt went down. From June 2004 to September 2005, both corporate bond yields and mortgage rates fell by about half a percentage point, while the Fed’s interest rate rose from 1% to 3.75%. Markets failed to get the picture, and as a result the Fed’s efforts to slow the economy and make the expansion of the 2000s more sustainable had failed. This failure has arguably made the recession of the global financial crisis far worse than it otherwise would have been.
What we have here is a communication error
Today, the Fed and other central banks around the world are trying to tell the markets that they intend to do so tighten Policy to get inflation under control. The result is theoretically a slowdown in the economy and lower prices. But instead of directing markets with clarity or useful ambiguity, the Fed has given them a heaping dose of confusion and contradiction this summer. Powell and other members of the FOMC have issued statements that are mutually exclusive or very different from previous communications. This has created a dangerous wedge between what the Fed wants and what markets expect. Even after a turn, there have been some notable communication failures this summer, suggesting that the communication approach needs some thought.
Take the June FOMC meeting for example: although the Fed has signaled for weeks that it plans to hike rates by 0.50%, the Wall Street Journal reported days before the meeting that the FOMC plans to hike rates instead 0.75% hike — the biggest rise in interest rates at a meeting since 1994. To explain the sudden shift, Powell pointed to a single poll that suggested Americans’ expectations for future inflation were too high for comfort . But that poll had a sample of just a few hundred people and was later revised down, which turned out to be a false positive.
Powell has flipped which measure of inflation the Fed monitors most closely: headline inflation, which includes commodities with volatile price changes like energy and food, or core inflation, which excludes those categories to gauge underlying price pressures. At the June meeting, when asked what kind of inflation the Fed was aiming for, Powell answered with the definitive statement “inflation means headline inflation”. But a month later, when gas and food prices started falling again, Powell turned around and said that “the core is actually a better predictor of headlines and overall future inflation” — the opposite of the stance he took at the had taken previous meeting.
Grizzled market watchers are likely to roll their eyes at anyone’s disappointment as Fed officials talk out of both corners of their mouths. But those same grizzled market watchers were likely puzzled by Powell’s prepared remarks from the July FOMC meeting, when he said that “it will likely become appropriate to slow the pace of rate hikes.” It’s a logical fact that the fastest pace of tightening in decades won’t continue forever. But by saying that explicitly, Powell gave the markets the opportunity to embrace much more.
These flip flops have thrown the markets into chaos. Stock prices plummeted after the mid-June session but rebounded after the subsequent session seemed to signal that the most intense rate hikes were over. The yield differential between risky and low-risk bonds also collapsed. That sounds like good news, but it actually represents a breakdown in the way monetary policy is transmitted to the rest of the economy.
To correct the market’s assumption that the worst rate hikes were in the past, Powell and other FOMC members spent weeks convincing investors that they were still sticking with rate hikes to keep inflation under control. At the annual economic policy symposium in Jackson Hole, Wyoming, in August, the chairman attempted to reverse the jubilant market move of late July and early August by sternly reminding his audience that to bring inflation down, the Fed would have to “give some pain.” Business.
That’s not to say that all markets haven’t gone the Fed route. Two-year bond yields, which roughly reflect market pricing for the US Federal Reserve’s interest rate 12 months from now, have risen steadily. While seizures continued to occur, the rise from a rate of less than 0.75% late last year to almost 4% today has been remarkably smooth and steady. But the orderly movement in Treasuries compared to the back-and-forth chaos in equities and corporate bonds only underscores the Fed’s inability to lay out its plans.
The good news is that the bond market is confident that the FOMC will manage to bring inflation down and surveys of consumers and businesses suggest inflation expectations have fallen along with gas prices in recent months. The Fed has long-term credibility, but the FOMC is making life much harder by changing its script.
Clarity above all
The FOMC has learned a clear lesson from this summer: communication is not working properly. Explicit forecasts or specific priorities are set
penalized by volatility and imbalanced positioning. Less communication in general would do the Fed good.
Since I began tracking all publicly available comments from FOMC members in June 2017, the average Fed spokesman has spoken publicly more than once a day — and that excludes Fed minutes and policy decisions or similar press releases. Powell has also started holding eight interest rate news conferences a year, double the number in 2018. If FOMC members said a lot less, there would be a lot less room for confusion.
The Fed was well served by repeatedly and publicly debating its monetary policy approach when it was not under pressure to tighten rates quickly. As the economy has changed, so has the Fed’s communications command. Less is more now – and will be enough to achieve the goal of informing the markets and the public without creating confusion.
George Pearkes is the Global Macro Strategist for Bespoke Investment Group.