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.