Forward Guidance Works!

I’ve argued repeatedly that the Fed does not have a communications problem. The problem lies with journalists and the market, which interpreted Ben Bernanke’s comments in June to mean that the Fed was set to taper no matter what. This interpretation caused interest rates on mortgages to rise in anticipation of the taper. But rising mortgage rates hurt the housing sector and reduce economic growth. The Fed took that into account along with some other below-average data and decided to forego tapering. Many journalists argued that the Fed miscommunicated its strategy in June, but that wasn’t the case. By misunderstanding the Fed, the market priced in a Septaper which forced the Fed to delay it.

This should have given Bernanke more credibility as Fed chairman. Instead of reducing the Fed’s bond buying without looking at the data, the Fed responded to weaker growth by delaying the taper. It should have been a sign to the market that the Fed really is data-dependent. Instead, most financial commentators argued that it was the Fed’s communication strategy that was at fault.

A month later and now there are signs that the message actually sunk in.  Here’s Neil Irwin:

This time five weeks ago, markets were ready and waiting for the Federal Reserve to begin its “taper,” the beginning of the end of its program of pumping billions of dollars into the economy by buying bonds.

Not only did Fed leaders elect to sit on their hands at that meeting; now the smart money thinks they won’t even start to slow their bond buying until this coming spring! That’s all the more remarkable given that there has been no radical shift in the tenor of economic data, just a series of mild disappointments, of which the September jobs report issued Tuesday morning was the latest example.

The market is listening to the data and basing their expectations of Fed policy on it! That’s exactly what Bernanke set out to accomplish with forward guidance. He wanted the market to have a good understanding of future Fed actions, but to do so, he had to outline a plan for how the Fed would act in the future. There was no set timeline for the taper given the uncertainty in the economy. That’s what he was saying in June, but he was also saying that if the economy continued growing at a moderate pace (which it hasn’t been), then the Fed would begin to taper its asset purchases. That was the baseline investors should use to predict Fed policy. If the data comes in above average, expect a greater reduction in bond purchases. If it comes in below average, expect those purchases continue for a longer period.

As Irwin writes, the (limited) economic data hasn’t been that much worse in the past month, but the expectations of Fed commentators have changed drastically. Those expectations are now aligned with the Fed’s intentions.

This is how forward guidance works.  I argued a little while ago that the real test of forward guidance would be how the market would react to underwhelming economic data. Here’s what I wrote:

If economic data continues to come in below expectations, the Fed will likely delay tapering yet again. Will the market realize that or will it once again blindly assume that the taper is coming? If the market does blindly assume that the Fed won’t adjust its policy, then the Fed must realize that forward guidance doesn’t work. Bernanke could not have made it more clear, both in his press conference and now by the action (or lack thereof) the Fed has taken, that the central bank is data-dependent. If the market has not learned by the next FOMC meeting, it’s never going to and the Fed must admit defeat.

Look what’s happened! Journalists and investors everywhere are pushing off when they expect the Fed to taper. This is the whole point of forward guidance. After the first government shutdown in 17 years, maybe it seems obvious that the market should assume that the Fed will keep up the pace of asset purchases into early next year (at least). But part of it is that Bernanke and the Fed laid out a roadmap for investors to follow depending on the underlying strength of the economy.

In that previous post, I lamented that forward guidance would be a failure if the market still expected a taper despite continued underwhelming economic data. Investors and journalists were never going to listen. But the opposite is true too. They are all reacting to the data and adjusting their expectations of Fed policy accordingly. That’s a new level of Fed credibility that didn’t exist a month ago and it’s a direct result of the Fed’s decision not to taper. It gave investors confidence in the future path of Fed policy.

That means forward guidance has been a major success.

Everyone Is Misreading The Fed Again

Well almost everyone. The conventional wisdom right now is that the Fed delayed tapering to fix its miscommunication in its June statement. The argument goes that the Fed should never have mentioned tapering and it was correcting itself by not cutting back its bond-buying. Here’s Bloomberg’s Justin Wolfers:

Chairman Ben Bernanke promised that future quantitative easing would depend on the incoming economic data. Those data clearly have been weaker than most analysts, including the Fed, had hoped. The only way for the Fed to convince markets that its policies are data-dependent is to make data-dependent decisions. Let’s hope this episode has helped rebuild some of the Fed’s credibility.

This whole taper debate is one that should never have happened. It’s the result of a failed communication strategy.

The point is that “taper off” doesn’t really represent an interesting new policy easing, but rather its main function is to undo the damaging tightening in financial conditions that occurred following the initial taper talk.

Wolfers analyzes the underlying situation correctly, but gets to the wrong conclusion. He says that the Fed is data-dependent and the economy worsened slightly over the three months in between the Fed’s June FOMC statement and its one two days ago. That should lead the market and investors to believe that the Fed would not taper, but it didn’t because none of them truly believed the Fed would adjust its policy based on the data.

The failed communications strategy wasn’t a Fed error. It was a forecaster error. I went back and read through the transcript of Bernanke’s June press conference last night. Every single time he mentioned tapering, he prefaced it by saying something like “if the incoming data support the view that the economy is able to sustain a reasonable cruising speed” or “[i]f the incoming data are broadly consistent with this forecast.” And guess what? The incoming data was NOT broadly consistent with this economic forecast.

This is where Tim Duy and I disagree. He writes:

I think this means that, in general, the data was broadly consistent with the Fed’s expectations.  That is, we weren’t reading the data wrong.  They just decided that they could wait until longer before initiating the taper.

The September FOMC statement did not do a good job of indicating that the data came in slightly below the Fed’s economic forecast. But Bernanke laid it out clearly in his prepared remarks:

in evaluating whether a modest reduction in the pace of asset purchases would be appropriate at this meeting, however, the Committee concluded that the economic data do not yet provide sufficient confirmation of its baseline outlook to warrant such a reduction. Moreover, the Committee has some concern that the rapid tightening of financial conditions in recent months could have the effect of slowing growth, as I noted earlier, a concern that would be exacerbated if conditions tightened further. Finally, the extent of the effects of restrictive fiscal policies remains unclear, and upcoming fiscal debates may involve additional risks to financial markets and to the broader economy. In light of these uncertainties, the Committee decided to await more evidence that the recovery’s progress will be sustained before adjusting the pace of asset purchases.

The Chairman is saying two things here: (1) the rise in interest rates since June have already lead to a tightening in financial conditions and (2) the potential for a government shutdown/default makes the Fed cautious. Overall, the Fed reduced its economic growth forecast slightly. Bernanke is explicitly saying that the financial data is not consistent with their June economic forecast. The Fed is adjusting its policy as the state of the labor market changes.

That’s why I think Duy and other journalists are misreading the data. The job reports have been mediocre at best. The labor force participation rate has declined. Average hourly earnings and average weekly hours have barely budged. The Commerce Department first revised its GDP numbers down from a 2.4% annual rate to one of 1.8% and then revised them back up to 2.5%. Mortgage rates have risen quite a bit.  All of these are indicators of a barely growing economy, one growing slower than the Fed expected in June.

In particular, the rise in mortgage rates happened as a result of the Fed’s June FOMC statement. Slate’s Matt Yglesias writes that “[t]he punchline is that the tightening of financial conditions in recent months was caused by … rumors that the Fed was going to taper.” Except there weren’t any rumors. There was the June statement that explicitly repeated over and over again that the Fed would only taper if economic data was positive. The market read that to mean that the Fed was going to taper no matter what and interest rates rose. Because interest rates rose, the economic data worsened and the Fed followed through on its promise to adjust its policy based on the labor market. If the market had read the Fed correctly and not assumed the taper was coming, rates wouldn’t have risen as much and the Fed’s economic forecast would have been sunnier. That may not have been enough to overshadow the other mediocre economic data, but the market also wouldn’t have completely expected the Fed to scale back its bond-buying. The non-taper wouldn;t have been a shock. The Fed and market would’ve been in sync. Instead, the market’s blind assumption that the Fed wouldn’t react to the data forced the Fed to do just that. Bernanke’s remarks didn’t cause the tightening of financial conditions. The market’s misreading of them did.

Once again, journalists are misreading what the Fed is saying. Bernanke isn’t saying that he regrets mentioning tapering in June. He regrets that the market misread him. That’s what the Fed was trying to correct this week. It was trying to tell the markets that it really is going to listen to the underlying data. It was trying to regain its credibility by precisely adhering to the statement it laid out in June. But, no one is hearing that. Everyone is misreading the Fed yet again.

The Fed’s Non-Taper Is All About Credibility

In a surprising move today, the Federal Reserve announced that it was not going to taper its bond-buying program. The Fed has been purchasing $85 billion worth of assets every month – $40 billion of mortgage-backed securities and $45 billion of long-term Treasuries. For months now, investors and journalists had expected the Fed to begin to decrease those amounts in today’s Federal Open Market Committee (FOMC) announcement. At 2 pm when the September FOMC statement came out, everyone was proven wrong:

 However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month

The stock market, bonds and gold all soared on the news of continued easy money while the dollar crashed. Why was everyone so sure that the Fed was prepared to taper today? It all goes back to the June FOMC meeting when Chairman Ben Bernanke first hinted at tapering. The Fed also upgraded its economic forecasts and in the press conference, Bernanke repeatedly emphasized the improvement in the labor market.

“If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year,” Bernanke said. “And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”

Interest rates on the 10-year Treasury note skyrocketed while stocks and gold both fell. The market took it all to mean that easy money was coming to an end soon.

Except that wasn’t what Bernanke or the Fed was trying to say. They were trying to say that if economic data continues to come in positively, then the Fed will scale back its bond-buying program. But only if the economic data is good. From the June FOMC Statement:

The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

If you read it literally, that statement clearly indicates that the Fed will react to labor market conditions in determining whether or not to taper. But the market parses every single word Bernanke says and it soon became conventional wisdom that a taper was coming. Dallas Fed Bank President Richard Fisher and Minnesota Fed President Narayana Kocherlakota both tried to walk back Bernanke’s statement and assert that a taper was not necessarily coming.

It didn’t matter.

But today, the Fed proved everyone wrong who parsed the statement and everyone right who read it literally. Subsequent jobs reports have been underwhelming, the Fed reduced its economic forecast today and the federal government is threatening to blow up the economy. If you listened to all of Bernanke’s comments and read the FOMC statement without overthinking it, you wouldn’t have been surprised by today’s announcement. The Fed said it would only begin tapering if the underlying economic data improved. But it worsened so the Fed shouldn’t have been expected to reduce its bond-buying. Yet, journalists and investors alike assumed that the Fed was still set on tapering, despite the underwhelming economic data.

With its announcement, the Fed was not trying to correct anything Bernanke said. It was trying to correct the market’s blind reading of the Fed’s statements. “Don’t just read that we’re going to taper. Read the caveats as well and take them into account.” Markets had assumed that when Bernanke mentioned tapering, it was set in stone that it would begin today. They did not believe for a second that poor economic data could delay it. Despite attempts to walk back Bernanke’s comments, the Fed could not credibly convince investors that it was not necessarily going to taper in September. By surprising the market and adjusting its policy based on labor market conditions, the Fed regained its credibility today.