The Inherent Problem With the Future

The reaction -- from disappointment to annoyance to surprise to shock -- was instantaneous. The Federal Reserve opted not to taper its monthly asset purchases yesterday after months of previews, conditionality and FAQs.

Yes, the U.S. stock market was ebullient, setting new highs knowing that Fed credit would flow at a pace of $85 billion a month. Economists weren't so happy and warned about the implications.

"The Fed Who Cried Wolf" was the title of a commentary by UBS economists (in a research paper to clients, so no link). "The Federal Reserve passed on an unusual opportunity: to begin the exit from quantitative easing without a potentially destabilizing market response," they write. "A consequence of this inaction may be that the market will view future Fed communications with some scepticism."

Credit Suisse economists Neal Soss and Dana Saporta expressed a similar view, one echoed throughout Wall Street after the meeting. (No link here either.)

"The straightforward implication of today's surprise FOMC 'no action' announcement is that the Bernanke Fed wants to stay easy," Soss and Saporta write. "It has a not-so-straightforward implication which is that it's not clear how much we should pay attention to Fed pronouncements."

The whole premise of forward guidance, be it on asset purchases or interest rates, is to say what you mean and mean what you say. Markets, according to theory, will factor the future into today's prices. Long-term interest rates rose more than 100 basis points in response to the taper chatter. It's a fair bet to assume that the Fed could have implemented a reduction of $10 billion or $15 billion without much effect on Treasury prices.

The inherent problem with any kind of forward guidance is that the future is always uncertain. You may mean what you say when you say it, but a few months later things look a bit different. President Obama prepared the nation for a military attack on Syria. Then he grasped onto a better, negotiated option when it came along.

The Wall Street Journal's Sudeep Reddy wrote last week that before yesterday's meeting, Fed governors (not bank presidents) had been silent for two months, the "longest stretch of time" since at least 1996. Perhaps it was incumbent on Bernanke to find a way to suggest he was reconsidering his options. Or maybe it was a recent change of heart.

I believe that Bernanke had every intention of following through when he started to prepare the markets in May for the gradual reduction in asset purchases and termination by the middle of next year. Something changed. My suspicion is that it was weak employment growth in July and August and downward revisions to previous months. Bernanke has spoken often about the corrosive effect of long-term unemployment: on the unemployed and on the nation as a whole in terms of lost productivity. Vice chair Janet Yellen shares those views.

The Fed did what it thought was appropriate yesterday, and it will have to live with the consequences, including the lost credibility voiced by many on Wall Street. (The stock market said, gimme some more!) Academics will have to reprogram their models if rational expectations are no longer a reliable input.

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