The FOMC surprised markets, economists, and almost everyone else who follows and whose decision processes are affected by what the Fed does. Markets had priced in a tapering, based upon both statements made by Chairman Bernanke immediately after the June FOMC meeting and follow-up statements made by several Federal Reserve Bank presidents representing a broad spectrum of views on policy. However, this month's statement by the Committee was not significantly different from recent previous statements, emphasizing the moderate rate of growth for the economy, concern about the employment situation, and a belief that inflation would remain benign.
Putting all that aside, however, the Committee interpreted incoming data as not adequately meeting criteria to warrant a change in either its accommodative policy or its present asset purchase policy. While markets breathed a sigh of relief that the party would still go on for a while, the bond market rallied, predictively. I say predictively because the backup in yields we have been observing in the bond market reflected anticipation that the Fed’s role in taking newly issued Treasury securities out of the market would diminish, thereby increasing available supply and, ceteris paribus, lowering price and raising rates. Since the Fed is not now scaling back purchases for the time being, supply constraints will continue in the newly issued market, and prices will be higher and rates lower, which is exactly what we have seen following the meeting. Despite the Fed’s theories on the importance of the size of its portfolio, flows do matter.
Aside from the obvious confusion about what the Fed’s communications policy is, the relevant questions now are, what incoming data will be critical to the FOMCs decision to taper and how will those data affect the path of tapering? “After yesterday we know less than we thought we did, and despite the Chairman’s nuanced discussion at the press conference of the many dimensions of labor market conditions, the communications now appear more muddied than clarified.
Here is one aspect of the FOMC’s forecasts, which somehow again were never tied directly to the policy decision. The Committee scaled back the central tendency of its growth estimates for 2013 by nearly a quarter of a percent, and the upper bound (2.4%) of the range is now almost equal to the lower bound (2.3%) of the June central tendency forecast. Similarly, the growth estimate was also lowered for 2014. Given the slow growth, it is difficult to understand how to reconcile the predicted continued improvement in the unemployment rate for 2013, but especially for 2014. What this disconnect suggests is that the unemployment rate is becoming less relevant or informative of labor market conditions, especially since 14 participants don’t see the first revision in the Fed Funds rate until either 2015 or 2016.
Finally, it is also interesting in the Summary of Economic Projections (SEP) that 9 participants had the Funds rate in 2016 at 1.75% or lower, while 11 were at 2% or lower. This implies that even if rates were to begin moving in 2015, they would still be substantially below the 4% rate considered by many to be the long-run equilibrium Funds rate. Moreover, the SEP funds rate projections suggest that the Committee has in mind a very gradual path for rate increases.
The question of how and when we start tapering and how we get there is probably less clear now than markets or economists thought before this September meeting. It demonstrates, the Chairman’s protestations notwithstanding, that the FOMC is far from having put in place a meaningful communications strategy and its so-called “forward guidance” is also called into question.
We know that FOMC communications strategy has been highly influenced by elegant economic models that rely on forward guidance and commitment as key elements to removing uncertainty from market decision making as the means to ensure policy effectiveness. Yet what events have revealed is that the FOMC values discretion in policy making above all, as witnessed by its insistence that policy moves and tapering are vaguely contingent upon incoming data. Such reliance is not forward guidance nor is it evidence of commitment. Perhaps it is time to stop relying on elegant, easily solvable models that assume specific forward guidance and firm commitment to deliver on that guidance, and look at models for policy formulation that explicitly allow for discretion and uncertainty.
Source: Cumberland Advisors