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.


Is Another Round of Quantitative Easing Coming?

Today was a special Jobs Day Tuesday as the Bureau of Labor Statistics released the September jobs report, which had been delayed due to the government shutdown. It wasn’t very good. Total non-farm payrolls increased by 148,000, which was less than the expected 180,000, while the unemployment rate dropped from 7.3% to 7.2%. The labor force participation rate remained unchanged at 63.2%. The July (-15,000) an August (+24,000) revisions combined for an increase of 9,000 jobs.This report was disappointing, but what’s even scarier is the trend lines.

Here’s the three-month moving average going back to the end of 2011:

3 month moving averageThere’s a pretty good chance that something is wrong with the way the BLS seasonally adjusts the numbers. Every winter has been much better than the following summer, but the trend is still not good. We’re into Obama’s second term and the economy is still barely growing. The reasons for this aren’t clear, but the government likely has a lot to do with it. Sequestration is terrible policy that is taking a chunk out of the economy at the wrong time. Austerity is the last thing we need right now. The expiration of the payroll tax cut at the start of this year is likely having some effect as well. And, of course, shutting down the government and risking a default is about as boneheaded as it gets. Instead of constructing policies looking to get the economy back going, the federal government (read: Republicans) have stood in its way.

The Federal Reserve has been concerned about fiscal policy and chairman Ben Bernanke has repeatedly emphasized that Congress needs to do more. Except that’s never going to happen. The question then is will the Fed do more? The economy is slowing down, not recovering. The FOMC had hinted at tapering in September, but pushed it off due to weak data and the impending fiscal fights. The market had assumed that the Fed was going to reduce its bond purchases regardless of the underlying data. By delaying the taper, the central bank attempted to regain its credibility and prove to investors that it’s data-dependent. Now, this is another test of that credibility.

This was a bad report and the economy is trending downwards. More fiscal fights loom and sequestration will be worse in 2014 than it was this year. Inflation is still running well below the Fed’s 2% target. If the Fed is really data-dependent, it will seriously think about making its policy even more accommodative either through QE4 or another mechanism.. The economy is no longer improving at a moderate pace. It’s slowing and there’s no chance that fiscal policy will help. It’s time for the Fed to pick up the slack.

The Unemployment Rate is Just One Indicator

One criticism of the Fed’s recent communication strategy has been that it relied too heavily on the unemployment rate as an indicator of the health of the labor market and communicated that reliance to the market. As I wrote earlier, the unemployment rate is falling, but the economy is barely improving. In his June prepared statement, Fed Chairman Ben 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 midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains

The Fed projections at the time expected the unemployment rate to be at 7.2-7.3% in the fourth quarter of this year. In August, the unemployment rate fell to 7.3%, well ahead of the Fed’s projections. Except this was not the result of above-average economic growth. On the contrary, financial markets tightened and the August jobs report was disappointing.  The drop in the unemployment rate was not representative of the overall economy.

Bernanke had hinted that the unemployment rate would be around 7% when asset purchases fully ended, but it had not even begun tapering yet. That was one major reason that so many journalists and investors expected the taper last week. Yet, this is once again not the Fed’s fault. The central bank could have done better in a number of areas. The long silence from the Fed governors provided little guidance for investors and Bernanke should have emphasized more that the Fed uses many different pieces of economic data to judge the labor market, not just the unemployment rate. But fundamentally, this was the market misreading the Fed.

Investors took one economic indicator and assumed the Fed would base its monetary policy on it. Worse, they knew that the drop in the unemployment rate was not the result of improving economic growth. It should have been common sense that the Fed would not that into account. But it wasn’t. There’s no doubt the Fed and Bernanke could have been more clear, like NY Fed president BIll Dudley was today and Bernanke was in his press conference last week. There, the chairman emphasized that the Fed looks at other economic indicators as well:

Last time, I gave a 7 percent as an indicative number to give you some sense of, you know, where that might be. But as my first answer suggested, the unemployment rate is not necessarily a great measure in all circumstances of the–of the state of the labor market overall. For example, just last month, the decline in unemployment rate came about more than entirely because declining participation, not because of increased jobs. So, what we will be looking at is the overall labor market situation, including the unemployment rate, but including other factors as well. But in particular, there is not any magic number that we are shooting for. We’re looking for overall improvement in the labor market

Too many commentators overreacted to what Bernanke said in June. The 7% unemployment rate number was treated as a trigger, not a threshold, even as Bernanke emphasized that it was the opposite. The unemployment rate was treated as the pivotal economic indicator influencing Fed decision-making. If you take a step back and look at the economic growth the past three months, there were few reasons the Fed would taper and many it wouldn’t.  The most important thing is that the economy underperformed Fed expectations. Yet, it was conventional wisdom that the taper was coming. That doesn’t mean Bernanke couldn’t have been clearer in June, but it means it was a fundamental misreading by journalists and investors. The Fed’s over-reliance on one economic indicator doesn’t change that.