MISCOMMUNICATION AT THE FED: Who’s the “Adult at the party?” MAS092115

During the Bernanke era, the FOMC made strides to create more transparency about the intended course of monetary policy. This was done with the view that monetary policy changes should be better understood by the public (the markets), and that this understanding would give both transparency of Fed actions but also that monetary policy itself would be more effective by making that policy more transparent.

In fact, the so-called “Woodford Doctrine,” elucidated at an earlier Jackson Hole conference (August, 2012), seemed to imply that the Fed actually possessed an additional weapon in its tool arsenal by communicating its long run policy guidelines. Woodford, of course, had advocated a simpler guideline, nominal GDP, to avoid potential situations of conflict between the explicit dual mandate of output and inflation. Woodford felt sticking to the guidelines was a powerful weapon for the Fed.

Given the dual mandate of output (employment?) and inflation, Woodford’s prescription should have given the Fed a kind of channel within which the Fed could and should operate. He did allow for the ambiguity of potential conflict between the two targets but long term guidance was not to be disturbed without clear indication that something very fundamental had changed: No surprises; clear intentions: longer run predictability of actions. Who really could argue with that?

Rumor has it that the ”adult at the party,” was less clearly disposed to accept this as a guidance criterion for the Fed. Fischer’s approach at Jackson Hole 2016 (See Ecomentary.com “Off the Table-On the Table: the Fischerine Query,” August 31 2015) seemed to imply that no firm channel existed or was even desirable. Some critics of Fed policy could note that the dual mandate criteria might well be insufficient as a guideline of Fed future policy. It appears to this observer that Fischer has had his way at the FOMC meeting of September 17, and the ambiguous statement of policy intentions contained in the Yellen Press Conference following the FOMC meeting that day is now the name of the game.

The press conference walked away from the dual mandate criteria and introduced external economic conditions as a compelling reason for the Fed to “wait a bit longer” before implementing its first dose of a return to monetary policy normalcy. It is to be noted that only a solitary dissent by District bank President Jeff Lacker accompanied the decision. To this observer the title of “adult at the party” has changed hats!

Bernanke’s view of transparency to which the market thought Yellen had subscribed was that abrupt and uncommunicated policy shifts were nugatory at best, damaging at worst and clearly not effective forward policy guidance. While Bernanke didn’t subscribe to an iron-clad rule (such as one of the versions of John Taylor’s rule or Milton Friedman’s percentage growth rule) it seemed reasonably clear that long term guidance for Bernanke implied the use of the same criteria for FOMC policy shifts, meeting to meeting unless something extraordinary had occurred. Bernanke didn’t exclude the possibility of discretionary actions from its long-term guidance—in the event of striking and unexpected developments in the economy—but it was clearly an attempt by Bernanke to place a bridle on a potentially bucking horse in monetary policy decisions. Where a decisive change in policy had to be installed, it would be in the context of full public pronouncements that the rules of the game had changed from a sharp and unexpected shift in economic conditions. Now comes the Yellen-Fischer concern with American financial policy in light of world developments that were widely known well before the FOMC met on September 16-17.

What’s gone wrong here? First, all of the reasons that Yellen cited for her “patience” policy had long been in the market. China, emerging market fragility, poor growth in Europe were not new conditions. They had been talked about at Jackson Hole and by market observers for many, many months. Meanwhile, the unemployment rate—with all of its weakness as a measure of labor market conditions—was steadily declining; and, Yellen herself had spoken of her wish to view labor market conditions in a larger perspective. As for inflation, the FOMC had said and continued to say that despite very recent deterioration from the 2% criterion, it fully expected prices “in the medium term” to rise up to the 2% target.

While various market reporters had signaled only a 50% probability as to the likelihood of a Fed rate increase, the reaction of equity and bond markets was one of shock. Clearly, the public as a whole had been conditioned to expect that the ‘return to normalcy’ was about to begin. The S&P fell sharply following the widely expected “return,” and world wide markets (closed at the time of the announcement on the 17th) rattled down decisively the next day. Anytime the Fed thinks that world wide conditions are very frail, the market is bound to think the Fed knows something that the market doesn’t know. Could it be that the FOMC with all of its expertise and adults at the party doesn’t know the impact of disappointed expectations? Does the FOMC think that equity markets are a bubble that needs pricking?

What Yellen accomplished at the FOMC meeting and subsequent press conference seemed to violate the long-standing transparency rules that the Fed once had! To put it differently, it was a MISCOMMUNICATION, and that is a polite description.

A more sober assessment is that the market can no longer take the Fed as following its previous communications policy. This Fed is not transparent. It has undermined any credibility that the Bernanke era gave it. The Bernanke rule was really the following: set a course (for the Central Bank); stay on the course in order to anchor expectations in the financial market; deviate only if extraordinary events begin to change that have threatened financial stability. It was a “rule by exception, and the exceptions should be few!

Nothing major has occurred either overseas or in the U.S. except the perpetuation of known trends. Therefore, the market’s expectation of a first rise in the target rate coupled to a trajectory of very slow normalization was “in the game.” The Fed changed its rules. It has miscommunicated. By doing so it may have dislodged its carefully placed anchor.

Investors beware. We are back to a pre-Bernanke Fed—to a world of possible, unexpected shifts in policy. Build more uncertainty into your market forecasts. The Fed has told you to expect less forward guidance that can be relied upon and more (whimsical?) policy making under the guise that the “U.S. is not an island.” We are back to the Greenspan days with its mumbled pronouncements.