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.

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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 Real Test for the Fed’s Policy of Forward Guidance

Stanley Fischer, the former head of the Bank of Israel, doesn’t think the Fed’s policy of forward guidance is beneficial for the economy. He believes it limits what the Fed can do in the future and confuses the market. Fischer is not necessarily wrong here. If the market does not believe that the Fed will adjust its policy to different labor market conditions, then forward guidance will continually cause shocks to the market as the central bank makes those adjustments. The Fed needs to credibly tell investors that it reacts to economic data. Last week’s non-taper put actions behind those words. Now, we’ll find out if the market has learned from it.

The markets are not listening to Ben Bernanke.
The market is not listening to Ben Bernanke.

The purpose of forward guidance is to give the market a clear understanding of the future path of monetary policy. As Fischer say though, the central bank itself doesn’t know what that path will be. This means that the Fed must condition its forward guidance on future economic data. If that data comes in as expected, the Fed will take the path it laid out. If it comes in above or below expectations, it will adjust its policy accordingly. When investors have a better understanding of future monetary policy, there are fewer shocks and swings in the market. Resources are allocated more efficiently between different asset classes and across different time horizons due to the predictable nature of policy. The market functions more smoothly. That is the rationale behind a rules-based monetary policy regime. Forward guidance is an attempt to implement a qualitative rules-based regime.

That’s exactly what Bernanke was trying to do in June, but the market overreacted and took it to mean that the Fed was set on tapering in September. That’s the problem with such a policy: if the market regularly overreacts to the Fed’s forward guidance, then it doesn’t work. When the market assumes that Fed policy is static and then the Fed adjusts its policy in light of the current economic conditions (as it said it would do), then wide swings in the market take place. This isn’t the Fed’s fault. It’s the market’s. The question is whether investors and journalists will realize that Fed policy is dynamic and forward guidance is only a guide. Mark Dow is skeptical, saying its human nature for the market to overreact and human nature doesn’t change. He may be right, but the upcoming months should test that theory.

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. In that case, Stanley Fischer would be right: forward guidance just confuses the market. However, I’m not ready to make that determination quite yet. We should know soon enough.