It had been a while since the market had been provided any
guidance from the Fed's de facto press secretary, the
Wall Street Journal's
Jon Hilsenrath, but late Friday he reemerged to provide his
valuable insight. In
Fed Officials Face Cliffhanger September Meeting
After Mixed Jobs Report
, he wrote:
Fed officials want to start scaling back their $85
billion-per-month bond-buying program this year and could take a
small step in that direction at their policy meeting Sept. 17-18.
But the economic data in recent months have been ambiguous and new
threats to the economy and markets loom, which could prompt
officials to wait longer before acting.
So they might taper and they might not. Thanks, Jon, you've been
helpful. The market understandably didn't care about what are
typically market-moving articles from Hilsenrath, but I took a
different view. I thought his comments point to the fundamental
flaw in the Fed's forward guidance communication strategy.
But in reality, officials have concluded over several months of
market volatility that it matters immensely what signal investors
take from their actions. They are deeply concerned that any move to
scale back the bond-buying program will be seen wrongly in markets
as a sign they're moving inexorably to end the program, a reaction
that could push long-term interest rates up even more.
The Fed still thinks the markets are misunderstanding policy.
Most troubling to top Fed officials is the risk that investors
will see a cut in bond purchases as a sign they'll start raising
short-term interest rates, which have been pinned near zero since
late 2008. The Fed has said short-term rates will stay low at least
until the jobless rate falls to 6.5% and possibly much longer.
The Fed still thinks tapering is not tightening. Hilsenrath writes:
Fed officials see that commitment as a more powerful tool than
the bond-buying program in their efforts to hold down long-term
interest rates to encourage borrowing, spending, investing and
growth and they want to reinforce it.
The Fed now thinks words speak louder than action.
The Fed is trying to better affect policy by being more transparent
and increasing communication with the markets through more
information flow. Here's the problem. The Fed tells the financial
media how they want markets to behave and the media, in turn,
reports market activity that is perceived to be a reaction to the
Fed's guidance, for which the Fed, in turn, recalibrates the
message to hone the guidance.
But what if the Fed is operating under a false assumption for how
their policies, both QE and forward guidance, impact the bond
market, and what if the media is incorrectly interpreting and
reporting the market reaction? What if the information flow is
incorrect? You will have a chaotic feedback loop between the Fed,
the media, and the markets. Like we have now.
It is a widely held belief that QE impacts interest rates through
two channels: the stock of bonds the Fed holds and the flow of the
purchases. The Fed believes that it is the stock of bonds they hold
that impacts interest rates. Ben Bernanke said it himself at his
April 2012 FOMC
There's some disagreement, I think, about exactly how balance
sheet actions by the Federal Reserve affect Treasury yields and
other asset prices. The view that we have generally taken at the
Fed in which I think -- for which I think the evidence is pretty
good, is that it's the quantity of securities held by the Fed at a
given time, rather than the new purchases -- the flow of new
purchases, which is the primary determinant of interest rates. And
if that theory is correct, then at such time that our purchases
come to an end, there should be relatively minimal effects on
interest rates at that time.
Well we now know this "theory" is not only incorrect, but has gone
horribly wrong. The Fed didn't think tapering would equate to
higher rates as long as their stock remained the same. The market
had different ideas.
Readers of my articles know that I have been pounding the table
that it is neither stock nor flow of QE that impacts interest
rates; it is the inflation discount. QE raised the inflation
discount in the curve and thus lowered real interest rates, finally
pushing them negative and thus forcing nominal yields to record
When the Fed backed off their commitment toward their stated
inflation target by floating the tapering idea despite no
inflation, the inflation premium collapsed and real rates blasted
higher taking nominal rates with them. When interest rates began
rising in May, TIPS breakeven spreads narrowed and the back of the
curve flattened. This is not because of the stock of the Fed's
holdings. It is a reduction in the inflation discount.
The Fed didn't really announce this with an FOMC decision, but
sometime in the spring they completely changed their policy from a
focus on QE to what is now deemed forward guidance, a.k.a. Jedi
mind tricks. Back on June 15 in
US Monetary Policy at a Crossroads,
I discussed this concept after Bernanke had dropped the hint in a
speech he gave to the
The framework for implementing monetary policy has evolved
further in recent years, reflecting both advances in economic
thinking and a changing policy environment. Notably, following
ideas of Lars Svensson and others, the FOMC has moved toward a
framework that ties policy setting more directly to the economic
outlook, a so-called forecast-based approach.
In 2003 Svensson wrote a working paper for the NBER titled
From a Liquidity Trap and Deflation: The Foolproof Way and
Thus, even if the nominal interest rate is constant at zero, the
central bank can affect the real interest rate, if it can affect
private-sector inflation expectations. If the central bank could
manipulate private-sector beliefs, it would make the private sector
believe in the future inflation, the real interest rate would fall,
and the economy would soon emerge from recession and deflation.
It sounds good on paper, but the Jedi mind tricks aren't going to
cut it and the market has spoken. Despite the emphasis on forward
guidance, once the market sensed the balance sheet would no longer
be expanding to effect inflation expectations, it began removing
the inflation premium. However the Fed sees the reaction to
tapering as a vote of no confidence in their commitment to holding
the Fed funds rate at zero until economic thresholds are met. This
is an incorrect interpretation for what happened, and both the Fed
and the media don't seem to get it.
The Fed and the financial media see interest rates (the 10-year
yield) rocketing higher and just assumes the market thinks the Fed
is going to start raising interest rates. The Fed and the financial
media think the curve is a function of future Fed funds
expectations (plus a term premium). The media tells the Fed the
market thinks Fed funds is going higher and the Fed tells the media
this is a misinterpretation of policy intentions. They are both
Yield Curve Interest Rate Risk Vs. Inflation Risk
The policy shift from QE to forward guidance has seen two dramatic
but very different shifts in the yield curve discount. The market
isn't pricing in higher Fed funds per se, the market is pricing a
higher interest rate risk premium in the front end (2-year/5-year,
eurodollar strip) and in tighter monetary conditions due to the
lack of QE in the long end (10-year/30-year, breakevens). The
market is raising the interest rate risk premium by steepening the
front of the curve due to the uncertainty of forward guidance (and
Larry Summers) moving toward a worst case scenario for Fed funds
rate hikes. The market is lowering the inflation discount by
flattening the back of the curve because tapering and an eventual
exit from QE means the days of excess dollar liquidity are over.
The Fed sees this curve dislocation and thinks they need to
strengthen forward guidance, so they call Hilsenrath on the bat
phone to try and talk the market back down, trying to convince
participants they are concerned about rates rising too fast.
Hilsenrath reports that the Fed might taper or they might not or
they might lower the economic thresholds or commit to zero Fed
funds for longer. The market hears this loud and clear and is
pricing the curve accordingly. There is nothing unusual to what is
happening in the bond market. The curve is rationally discounting
what has become
monetary policy chaos
The problem is not that the Fed is tapering. The problem is the Fed
is trying to calibrate policy based on a market discount they
misinterpret through communication they misunderstand. The problem
is policy chaos. It's become obvious the Fed doesn't really
understand how the market works. First the Fed erred in relying on
the stock theory of QE, and now they are basing forward guidance on
a misunderstanding of the yield curve discount. As a result,
leveraged investors across global capital markets are delevering en
masse and liquidity is tightening rapidly.
This policy shift was, in theory, designed to increase transparency
and decrease volatility, but the opposite has occurred because Fed
policy is based on a fundamental flaw. We don't need stronger
guidance or the market to have confidence in the Fed. We need less
guidance and for the Fed to have confidence in the market.