More on the Fed’s haphazard move to forward guidance over QE
Summary: Last week in the lead up to the FOMC meeting, I went through why I believed this meeting would mark a shift away from the QE regime. And while the Fed did not taper, indeed we are seeing a greater emphasis on forward guidance as a policy tool. Unfortunately, the Fed has been ham-fisted in making this transition. Some thoughts follow below.
The Fed did not taper as most of us expected. I realized the data were weak: inflation was below the Fed’s informal red line, unemployment is still high, jobs data have been somewhat disappointing, and recently the PMI has fallen. I was most concerned with the rise in mortgage rates due to the widespread belief that tapering meant an accelerated tightening schedule. But, we also have the spectre of fiscal crisis coming forward. So, it makes sense that the Fed would hold off. I just believed that they were committed to the signals they had sent on QE.
And herein lies the problem.
Just after the Fed stood pat on QE, Bernanke stressed in his post-FOMC press conference that we are entering a regime shift, saying the Fed believes forward guidance was “stronger and more reliable” than QE as a policy tool at this juncture. This is exactly what I predicted the Fed would say. But it’s not whether the Fed would move to a forward guidance regime that matters. It’s how they are doing so.
The Fed has been signalling very strongly that they are prepared to taper large scale asset purchases this year and the market had coalesced around September as the month when this would begin. Everywhere we were hearing September and everyone was saying it. The Fed had to know this was what the market expected. Yet, the Fed decided to surprise the market and delay tapering. The immediate effect was to produce a broad rally in shares and bonds and this has given emerging markets a lot more breathing room. So the move has been good for asset markets, which is exactly what the Fed wanted. But the longer-term effects are negative.
The reason that forward guidance works and why Bernanke and the Fed believe it is superior to QE is because it has a direct effect on credit conditions whereas QE only has an indirect effect. Because banks are not reserve constrained, adding excess reserves does not in and of itself fuel credit creation. So QE doesn’t ease credit conditions directly. Rather QE works via the portfolio balance channel by taken assets out of the aggregate private portfolio and adding reserves in their place. This should put downward pressure on rates and thus spur more lending.
Forward guidance – if credible – tells the market directly what the Fed intends to do going forward. And since long-term interest rates are really composed of three parts, short rates, expected future short rates and a term premium, then the Fed can directly change long-term rates by altering expected future short rates (or altering the term premium). But what the Fed has done by not tapering is introduce uncertainty about its timetable into the picture even while it has lowered expected future short rates. This means that over the short-term rates are now significantly lower as the Fed intended; they were alarmed at the backup in mortgage rates.
Forward guidance only works if it is credible. Forward guidance suffers from time inconsistency problems because the Fed has every incentive to alter its guidance when events change and the market knows this. They therefore will front-run the Fed if they believe the guidance will change. Thus the only way to minimize this time inconsistency is to be very assiduous in sticking to guidance and not deviating. By surprising the market, the Fed has undermined its credibility and thus increased time inconsistency problems that are going to undermine forward guidance as a tool down the line.
What does this mean for the markets? Over the short-term it means nothing because we now see that the Fed is going to be on easy street for a long while as the market should have realized from the start. Yet, down the line, when the Fed does taper and move toward forward guidance as the principal signalling tool, it will lack credibility and time inconsistency will be a big problem. I expect volatility. And so from a trading perspective, it pays to be long volatility in Treasuries if this is the case going forward.
The Fed will largely live up to its forward guidance schedule. However, it has now shown us that it is not as committed to that schedule as I thought it was. However, I believe a Yellen Fed would be more committed to sticking to forward guidance assiduously. Therefore, we should expect a Yellen Fed to reduce time inconcistency, reduce volatility and keep rates low until employment has recovered.