- Forward guidance proving less useful at mapping rate hikes
- Data dependency creates market uncertainty in interpretation
The U.S. Federal Reserve’s decision next week on whether to raise interest rates is a vital issue for markets and investors around the world. Problem is, all the speeches, forecasts, meeting minutes, press conferences and media interviews given by Fed officials in the lead up is muddying, not clarifying, the outlook.
Case in point: Boston Fed President Eric Rosengren on Sept. 9 said the economy could overheat if they waited too long to raise interest rates, contributing to a 2.5 percent rout in the S&P 500 Index that was the biggest move since the U.K.’s vote to leave the European Union. Three days later, Fed Governor Lael Brainard argued there’s no rush to tighten, helping lift the S&P 500 by 1.5 percent in the equity benchmark’s biggest one-day reversal since January.
“To say the Fed is confusing is an understatement,” said Hao Hong, chief China strategist at Bocom International Holdings Co. in Hong Kong. "The more speeches, the more room for confusion."
Even though futures markets show expectations of about a one-in-five chance of a September rate increase, a simple suggestion in the Fed’s statement, its forecasts or Chair Janet Yellen’s press conference that rates are going higher soon has the potential to send stocks, bonds and currencies into a tailspin from Brazil to South Korea. Starting Tuesday, Fed officials have entered the traditional self-imposed period of public silence before a policy meeting.
To steer investors, the Fed’s main form of forward guidance is the median interest-rate forecast in its dot plot, which it will refresh at the Sept. 20-21 meeting. The median rate communicates an intended pace of hikes now, but not uncertainty around that outlook. The Fed’s statement reminds investors that “the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”
That data dependence has seen the Fed’s outlook change dramatically in just a few months. For instance, their estimate of what interest rate keeps supply and demand in balance in the economy over the longer-run fell a half percentage point to 3 percent from December to June. Indeed, this year could still turn out to be one in which the Federal Open Market Committee predicted four rate increases yet delivered none.
In a world of high uncertainty, going slow has been the Fed’s default. Jon Faust, a former special adviser to Yellen, calls it a “feel-forward” strategy. “They are doing something that has never been done before where they don’t understand how their tools are working,” said Faust, now a professor at Johns Hopkins University in Baltimore.
Outside the U.S., observers haven’t been sympathetic. Erik Nielsen, chief economist at UniCredit Bank AG in London, wrote this month that the Fed has “lost its way.” Stephen Jen, CEO of Eurizon SLJ Capital Ltd. in London, told clients recently that Fed watching “has been the single biggest waste of my time in the past two years.”
One source of criticism: Fed officials have repeatedly complained that financial markets are underpricing the chance of rate increases -- only to then refrain from raising rates.
"There are too many speeches that are contradictory to each other," said Shen Jianguang, chief Asia economist at Mizuho Securities Asia Ltd. "It is difficult to convey a clear message if there is clearly internal disagreement."
To be sure, it’s not as if other central banks have found it any easier to steer investor expectations. The economics profession itself is ragged with disagreement over everything from where the natural rate of interest lies to how inflation functions.
The Bank of England has also been at the sharp end of market and lawmaker ire. Governor Mark Carney entered office in 2013 full of enthusiasm for a forward-guidance program that tied rate increases to a decline of the unemployment rate beyond a certain point.
That guidance had to be amended after unemployment fell much faster. The messaging then reversed completely after the U.K.’s vote to leave the European Union meant the central bank had to start thinking about easing policy rather than tightening it.
The European Central Bank has avoided tying its own guidance to any specific economic indicator, such as unemployment or the inflation rate. ECB President Mario Draghi reiterated in Frankfurt last week that the Governing Council expects interest rates “to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases.”
Other central bankers have also found their own ways of befuddling investors. Bank of Japan Governor Haruhiko Kuroda ruled out negative interest rates in January, and then introduced exactly such a policy the same month.
The Chinese central bank takes an opposite tack. While the People’s Bank of China says it is striving to improve communication, Governor Zhou Xiaochuan said in June that complex market messages are best channeled through a small clique of experts who then filter it out to the general public.
Markets, meanwhile, are trying to sort through it all. The extra yield that U.S. 30-year bonds offer over five-year notes shrank to the smallest in more than a year after Yellen indicated in August that the case for tightening policy had strengthened. Yet the spread widened significantly in recent days as investors sold longer-dated debt, questioning the European Central Bank’s and the Bank of Japan’s commitments to their respective bond-buying programs. Sovereign bond yields rose to the highest level in almost three months as Mohamed El-Erian said the Fed should hike.
In the U.S., forward guidance was instrumental in preventing spirals of uncertainty when market conditions were fragile, such as after the collapse of Lehman Brothers Holdings Inc. in 2008, according to Lena Komileva, chief economist of G Plus Economics in London.
“That’s not immaterial as a benefit,” she said. “But the markets are confused about what forward guidance and data dependency mean” when policy is being tightened, she added. “Forward guidance has been the cloth hiding central banks’ insecurity about economic forecasting.”
And when that insecurity is displayed in full by the Fed -- which determines the cost of funding in the world’s main reserve currency -- that makes it tougher for other central banks to make their own forecasts and set policy, Komileva said.
With the chairmanship of Ben Bernanke, the Fed moved decisively away from relying on the kind of gnomic utterances that kept investors guessing under Alan Greenspan. Now, it may be difficult for the central bank to dial back its current information overload.
“To say you are going to be data dependent is just inviting markets to react to every piece of information because you don’t have an overall framework,” according to David Papell, chairman of the Department of Economics at the University of Houston.