Fed Running Out of Forward Guidance as Markets Exhaust Toolby
Drop in long-term interest rates leaves little room for shift
Waning ability to offset shocks tightens financial conditions
Janet Yellen says one of the tools the Federal Reserve can use to fight the next recession is a pledge to keep interest rates low for a long time, but the economist who led the intellectual charge to deploy such forward guidance isn’t so sure.
"Even a dramatic announcement that ’we’re heading back to zero and staying there’ would not be that much lower a path for rates than the one that markets are currently expecting," said Michael Woodford, an economics professor at Columbia University in New York whose work on forward guidance has had a major influence on central banking since the financial crisis.
After the Fed cut overnight interest rates to near zero in 2008, it was able to supplement its support of the U.S. economy by promising to keep them low for a long time. That signaling helped policy makers to continue reducing long-term interest rates, which affect everything from the cost of mortgages to auto loans, without further rate cuts.
This year, the Fed’s ability to use forward guidance has been significantly reduced, and the next bout of market turmoil may take it away entirely. When the U.S. central bank hiked rates in December for the first time in nearly a decade, pricing in bond markets was consistent with seven more quarter-percentage point increases over the next five years.
That number has since shrunk to just three. Longer-term interest rates plummeted when investors took fright amid global market volatility early in the year, and took another step down in June when Britain unexpectedly voted to leave the European Union.
"Given that market expectations are already for a path that rises above zero only very slowly over the next few years, there is not too much room to change those beliefs," Woodford said.
The quandary helps explain why the policy-setting Federal Open Market Committee hasn’t increased its target range for overnight rates again after raising it to 0.25 to 0.5 percent in December, a move that marked the first hike in nearly a decade.
The committee next meets Sept. 20-21, and is expected to leave rates unchanged once again. The argument that it has much more scope to respond to a stronger-than-expected economy than it does to another negative shock “is going to be a principal reason why” they don’t raise rates this month, said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York.
Financial-market turmoil in January and February highlighted the asymmetric risks faced by officials with rates so low, and the need for policy to respond to such shocks when the economy is already growing so slowly. Yellen, the Fed chair, referred in a March 29 speech to the drop in the expected future path of overnight rates in response to market volatility as an “important automatic stabilizer” for the economy.
Fed Governor Lael Brainard echoed those remarks Monday, saying during a speech in Chicago that “the economy has seen welcome progress on some fronts in recent months, supported by the cautious approach taken by the committee and a corresponding easing in financial conditions.”
Policy makers projected in June that it would be appropriate to raise overnight rates by two percentage points by the end of 2018, according to the median forecast of their so-called dot plot. With markets pricing less than two quarter-point hikes between now and then, Fed officials’ own projections significantly overstate the scope for them to ease by lowering their dots to signal a shallower path of future rate hikes.
With less room for adjustment in the policy stance, the potential for market turmoil to chill the economy has gone up. Investors put the chances that overnight rates will be lower two years from now than they are today at better than one in four, nearly twice as high as at liftoff in December, according to prices of options on eurodollar futures contracts.
“The risk that you will face shocks that you cannot comfortably overcome is larger than it’s been, and we are limited under current circumstances in ways that we have not been before,” said Lewis Alexander, the New York-based chief economist at Nomura Securities International Inc. “That’s potentially a problem.”
In the event of a full-blown economic downturn, the Fed could still return to the bond-buying programs it employed in the last crisis to push longer-term rates down toward zero, but the bar for doing so may be higher than if they had scope to ease via forward guidance, Alexander said.
“There is part of it you can do with forward guidance, and there is part of it you can do with going out and buying a bunch of stuff,” he said. “Could you transition to quantitative easing in time to prevent you from going into a recession? That’s probably a stretch.”
Investors, for their part, are aware of this, and that knowledge could lead to greater tumult in financial markets going forward, according to Jeremy Lawson, chief economist at Standard Life Investments in London. With reduced capacity for central bankers to mitigate unexpected shocks, “there is going to be an underlying fragility to financial markets,” he said.
Further declines in long-term interest rates in the interim will probably strengthen the hand of those on the FOMC who argue that the Fed be extra-cautious about raising rates in the near term, but also that it should consider intentionally overshooting its 2 percent inflation target.
The Fed’s preferred gauge of price pressures has been below that goal for more than four years, though another measure compiled by the Labor Department showed prices in categories excluding food and energy rose 2.3 percent in the year through August, according to a report released Friday in Washington.
“If you really ultimately want to get to higher rates, paradoxically, the best way may be to overheat the economy now by keeping them too low for too long,” said Joseph Gagnon, a former Fed economist who is now a senior fellow at the Peterson Institute for International Economics in Washington.
“I think that is sort of what they’ve been thinking,” he said. “The continued slowness of core inflation to adjust, and continued worries about the world economy, are just causing them to wait.”