A couple of weeks ago, this column reported on a Finance Experts Panel poll on the Fed’s new communications strategy. Or, as it might be termed, anti-communications strategy.
Kevin Warsh, the new Chair, has taken a radically different approach to his most recent three predecessors. As that column explained, ‘he worries that forward guidance means that markets are less likely to price in new information coming from economic surprises’.
But while there may be a case for offering less forward guidance in a more uncertain world, as several Finance Panel participants were keen to emphasize, he would still need to be clear on the Fed’s reaction function.
Many of those disagreeing argued that whatever communications policy the Fed wants to adopt it will still need to clearly explain its reaction function (or how it will likely react to new news) to financial markets. As Loretta Mester of Wharton argued, “The Fed needs to provide information on its reaction function: needs to convey its view on future policy conditional on how the economy evolves and not regardless of how the economy evolves. Without this the Fed won’t be able to infer the market’s view on econ as Chair Warsh desires”.
Of course, one person’s “explaining their reaction function” can very much be another’s “offering forward guidance”. The real debate amongst FOMC members is likely to be over exactly where that line is drawn.
As Stijn Van Nieuwerburgh of Columbia Business School argued at the time, “Literature shows that better communication reduces uncertainty. But we need clearer explanation of reaction function, state-contingency of policy instead of calendar-based guidance, separation of Fed outlook from policy commitment”.
This week, it is fair to say, Warsh’s press conference left investors scratching their heads.
“I understand the desire for rolling forecasts and commentary from this committee, but for our part, we need to observe market reaction to developments, direct and unfiltered,” Warsh said in his opening remarks Wednesday.
The news conference that followed left some economists baffled.
“I thought today’s press conference was confusing and often internally contradictory,” Eric Winograd, chief U.S. economist for AllianceBernstein, wrote to clients.
Two economic developments are worth highlighting. The first is a very notable change since our last meeting 42 days ago: nominal and real yields are materially higher across the Treasury curve. In fact, some of the increases in market interest rates between FOMC meetings are among the most significant in the last two decades, ranking around the top decile or so. But if the Committee didn’t change its policy rate, what happened? In the inter-meeting period, market attention centered on real data and real economic developments. Prices reacted in real time to incoming information, and the reduction in forward guidance may have been a factor. Market participants are learning to play the ball, not the referee—and market prices will continue to respond in the direction and magnitude they see fit. This is, in my view, a change for the better—and we are just getting started. After all, the central bank need not always and everywhere be the center of attention. I understand the desire for rolling forecasts and commentary from this Committee. But for our part, we need to observe market reaction to developments, direct and unfiltered. I want to stress, of course, that decisions by this Committee matter a great deal. And where necessary and appropriate, we will not hesitate to act.
Here Warsh seems to be claiming some sort of victory for his new approach, arguing that the lack of guidance means that bond markets have been able to focus on actual economic developments rather than second-guessing how the Fed will react.
… start with the fact that the Fed sets short-term interest rates. Of course, market participants who are betting on the direction of short-term rates have to form a hypothesis about what the Fed is going to do. They will form this hypothesis using whatever information is at hand. Whether the Fed’s press releases are long or short, or whether the chair’s answers to hard questions are substantive or vacuous, this remains the case.
In other words, investors cannot simply react to economic news without, on some important level, second-guessing how the Fed itself will interpret that news. The Fed can, if it so chooses, be more or less explicit about how it sees the future unfurling. But if markets do not have a sense of how the Fed is likely to react to developments, then risks of mispricing develop.
He’s been adamant about not issuing “forward guidance,” or an indication of what the Fed might do in the future, and yesterday he argued it’s working. While Warsh isn’t speaking much about what he thinks Fed policy should do, other Fed officials still are. Some analysts said the Fed chief’s characterization of what’s going on in markets isn’t right — investors are listening to his colleagues, trying to forecast what the Fed might do, then pricing that in.
What we investors have been left with is confusion. The Fed Chair seems to want to learn useful information from watching bond market moves, but those in the bond markets first need to learn something from the Fed Chair.
Until the reaction function is clearly set out, this confusion will continue.
