March 21, 2023

The Federal Reserve has a public relations problem.

In an effort to rein in overheated inflation, the Fed has tried to signal to investors and financial markets its plans to deal with rapid inflation. For monetary policy and interest rate hikes to work, markets must clearly perceive the Fed’s objectives and be consistent with those objectives. But recent communications from Chair Jerome Powell and other Fed officials have been confused at best — and you only have to look at the significant market swings over the summer to see the missteps that have been made.

This is a problem not just for Powell and the Fed, but for the economy. If investors stop listening to the Federal Reserve, even perfect decision-making by the Federal Open Market Committee—the Fed’s main interest rate-setting committee—could produce a tragic misstep that’s either too blunt or too unpleasant. To actually deliver the desired amount of tightening and reduce inflation without losing control of the process, the Federal Reserve needs to clarify how it interacts with markets.

Playing the expectation game

Markets are forward-looking by nature, anticipating a company’s future or economic growth over the next few years. To steer the economy toward its desired outcomes, the Fed plays on this future-oriented nature of steering Financial status. As economic conditions change, markets consider what the Fed and other central banks will do next. By hinting at future interest rate cuts, the Fed hopes to send a signal that drives businesses to rent and invest while households spend more — boosting the economy. In signaling an interest rate hike, the Fed hopes to dampen asset-price growth and confidence, reducing consumer and business spending.

Using monetary conditions to manipulate the economy has proven very useful for the Fed in the past. After the global financial crisis, interest rates were already near zero, so there were limits to how much more the Fed could stimulate the economy. One solution was to telegraph an intention to keep interest rates low until the economy stabilized, a strategy called Forward instructions. Forward guidance means markets can price lower rates long into the future, helping to keep the stock market strong and mortgage rates low even though the Fed can no longer cut interest rates.

Other times, this signal didn’t go over well. When the Fed began hiking rates in 2004, private-sector borrowing costs actually eased. From June 2004 to September 2005, corporate bond yields and mortgage rates both fell by about half a percentage point while the Fed’s key interest rate rose from 1% to 3.75%. Markets failed to get the picture, and as a result, the Fed’s efforts to slow the economy and make the expansion of the 2000s more sustainable failed. This failure arguably made the global-financial-crisis recession much worse than it otherwise would have been.

What we have here is a failure of communication

These days the Fed and other central banks around the world are trying to tell the markets what they want to tighten Policy to control inflation. The result, in theory, is a cooler economy and lower prices. But instead of guiding markets with clarity or useful ambiguity, the Fed has fueled them this summer with confusion and conflict. Powell and other members of the FOMC made statements that were mutually exclusive or completely different from previous communications. This has allowed for a dangerous wedge between what the Fed wants and what the markets expect. Even grading on a curve, this summer has seen some significant communication errors that suggest a need to rethink communication methods.

Take June’s FOMC meeting, for example: despite the Fed signaling for weeks that they plan to raise rates by 0.50%, The Wall Street Journal reported this A few days before the meeting the FOMC planned to raise rates by 0.75% instead – the largest rate hike at a meeting since 1994. In explaining the sudden shift, Powell pointed to a single survey that found Americans’ expectations for future inflation were too high. High for comfort. But this survey There were only a few hundred people sampled And later corrected, it proved to be a false alarm.

Powell flip-flopped on which measure of inflation the Fed is monitoring most closely: headline inflation, which includes changes in the prices of goods such as fuel and food, or core inflation, which strips out these categories in an attempt to measure underlying price pressures. At the June meeting, Powell responded to a question about what kind of inflation the Fed is targeting by saying a certain “inflation means headline inflation.” But a month later, when gas prices and food prices began to fall, Powell stepped in and said that “principals are actually a good indicator of the progress of headlines and all inflation” — the opposite of the position he had taken. previous meeting

Grizzled market watchers will likely roll their eyes in frustration when Fed officials talk out of both sides of their mouths. But those same grizzled market watchers were likely confused by Powell’s prepared remarks from the July FOMC meeting, when he said it would “probably be appropriate to slow the pace of increases” in interest rates. It is a logical statement that the rapid pace of tightening over the decades will not continue indefinitely. But clearly, Powell has left the market open to much more speculation.

These flip-flops have created chaos for the market. Stocks fell after the mid-June meeting but appear to signal the sharpest rate hike since the next meeting. The yield differential between risky and low-risk bonds has also collapsed. This sounds like good news, but it actually represents a breakdown in the way monetary policy is transmitted to the rest of the economy.

To correct market assumptions that the worst of rate hikes was in the past, Powell and other FOMC members spent weeks trying to convince investors that they were still committed to raising rates to get inflation under control. At the annual economic-policy symposium in Jackson Hole, Wyoming, in August, the chairman tried to reverse the bullish market action of late July and early August by sternly reminding his audience that the Fed would “have to inflict some pain” on the economy to reduce inflation.

That’s not to say all markets haven’t picked up on the Fed’s path. The yield on the two-year note, which roughly determines the market price of the Fed funds policy rate 12 months ago, rose steadily. Although in fits and starts, the move from a low rate of 0.75% late last year to around 4% today has been remarkably smooth and steady. But the orderly move in Treasury bonds compared to the back-and-forth chaos in stocks and corporate bonds only underscores the Fed’s inability to build on its plans.

The good news is that the bond market is confident that the FOMC will succeed in reducing inflation, and consumer and business surveys suggest that inflation expectations have fallen along with gas prices over the past few months. The Fed is credible in the long run, but the FOMC is making its own life a lot harder by changing its script.

Transparency above all else

There is a clear lesson for the FOMC from this summer: communications are not working properly. Having a clear forecast or specific focus point

Punished by instability and unbalanced positions. Less communication in general would serve the Fed well.

Since I began tracking all publicly available comments from FOMC members in June 2017, a Fed speaker has spoken in public an average of several times a day—and that excludes Fed minutes and policy decisions or similar press releases. Powell has begun giving eight interest-rate press conferences per year, twice as many as in 2018. If FOMC members say much less, it leaves much less room for confusion.

The Fed was well served by repeatedly and publicly discussing its policy approach when it was not under pressure to tighten rapidly. As the economy has shifted, so have the Fed’s communication needs. Less is more – and will be sufficient to meet the goal of informing the market and the public without causing confusion.

George Pearks is a Global Macro Strategist Bespoke Investment Group.

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