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False Promise of the Fed's Forward Guidance

A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” Some portfolios he manages invest in currencies and commodities.
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The 2008 financial meltdown exposed a lack of transparency in the financial system. The U.S. Federal Reserve, in response, sought to provide more openness and fewer surprises with forward guidance -- early indications of changes in monetary policy to guide investors, businesses and households. The Fed's hope was that providing information about likely changes could reduce market disruptions. 

I have long been skeptical of the effectiveness of forward guidance because future changes in monetary policy are heavily dependent on data that are not yet known. Worse, the Fed has consistently been too optimistic about the economic recovery, making its forward guidance ineffective.

QuickTake Forward Guidance

In 2012, the Fed forecast 3.4 percent growth for 2015, but gradually cranked that down to 2.1 percent, the average annual growth rate since the recovery started in mid-2009. It similarly cut to 2 percent from 4 percent its initial forecasts for 2012, 2013 and 2014. 

To assess whether forward guidance has been effective in preventing market disruptions, compare today's economy with the market conditions of the mid-1990s, prior to its use. Of course, there are significant differences in inflation, global growth and other measurements, yet the differences in volatility between then and now are stark. 

The Fed raised short-term interest rates in February 1994 without warning. It pushed rates up six more times by November 1994, doubling the federal funds rate to 6 percent. This caused Treasury yields to skyrocket in what became known as the great bond massacre of 1994.

Yields on 10-year Treasuries jumped 2.3 percentage points to 8.1 percent, for a price loss of 23 percent. The 30-year Treasury-bond yield leaped by 1.9 percentage points for a principal decline of 17 percent. The index that measures stock-market uncertainty reached a high of 23.9 in April, compared with a 10.8 level before the first rate increase.

Ditto for Treasury volatility, which is measured by taking the 20-day moving average of the daily percentage change in yield. For 10-year Treasuries in 1994, volatility rose from 0.5 percent at the start of the year to a peak of 1.2 percent, while volatility in the 30-year bond climbed from 0.4 percent to a peak of 1 percent.

If forward guidance worked, you’d expect less stock and bond volatility now -- even more so with all the Fed’s talk of raising rates. Nevertheless, forward guidance appears to be stirring up markets, not calming them down. Stock and bond market volatilities have jumped to levels vastly exceeding those of the mid-1990s.

The Fed indicated it might raise rates in June, September and now December. From their February lows, yields have risen 68 basis points (100 basis points equals one percentage point) on the 10-year Treasury note and 87 basis points on the 30-year Treasury bond.

The 1994 yield increases were higher. Still, the volatility index jumped to 40.7 in late August, almost twice the 23.9 high of 1994. Similarly, our index of Treasury volatility this year reached 2.9 percent for the 10-year and 2 percent for the 30-year -- more than double the 1994 levels. 

Why are stock and bond volatilities twice as high with forward guidance than without it? Anticipation of a Fed rate rise and China's economic slowdown have roiled stock markets. Also, I believe higher bank capital requirements have led to less liquidity, and therefore higher volatility, in Treasuries. 

But forward guidance is also a culprit due to the Fed’s chronic overoptimism about economic growth and its persistent warnings of an imminent rate increase.

The Fed isn't alone with its embarrassingly overoptimistic forecasts. The International Monetary Fund and the World Bank keep reducing their outlooks for global growth. Economists in the Wall Street Journal’s forecasting surveys have also persistently cut their growth forecasts. 

The Fed’s use of forward guidance has been ineffective due to its inability to correctly forecast economic conditions. And this probably led to more, not less, market volatility. Back when the Fed surprised investors, stock and bond market volatility was half of today’s levels. 

Instead of continuing to do the same thing repeatedly and expecting different results, why not just abandon forward guidance? 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
A Gary Shilling at insight@agaryshilling.com

To contact the editor responsible for this story:
Paula Dwyer at pdwyer11@bloomberg.net