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The Federal Reserve has a problem with members of the public family.
In an attempt to curb soaring inflation, the Fed tried to sign off on its plans to combat rapidly rising interest rates to investors and economic markets. To ensure that financial policy and interest rate hikes work, markets must evidently support the Fed's wishes and fall in response to these objectives. However, recent communications from Chairman Jerome Powell and other Fed officials have been puzzling – and you'd better watch the considerable market shifts over the summer to see what mistakes were made.
This is an issue that is not easy for Powell and the Fed, but for the economy. If traders stop paying attention to the Federal Reserve, even perfect decision-making using the Federal Open Market Committee – the Fed's main hobby spending committee – can create a tragic misstep; it's either too hawkish or too dovish. To actually convey the desired amount of tightening and reduce inflation without losing control of the system, the Federal Reserve must clean up how it communicates with the markets.
playing the video game of expectations
Markets are, by nature, forward-looking, anticipating the path forward for a corporation or the next few years of economic boom. To move the economy toward its desired outcomes, the Fed acts in this future-focused manner with the aid of guidance-oriented fiscal situations. As financial circumstances are negotiated, markets take into account what the Fed and other major banks will do next. By signaling future spending cuts, the Fed hopes to send a signal that prompts businesses to hire and invest while households spend more – boosting the economic climate. By signaling that interest rate hikes are coming, the Fed hopes to gradually increase asset prices and undermine confidence, reducing spending with the help of consumers and businesses.
The use of fiscal situations to modulate the financial system has proven extremely valuable to the Fed in the past. After the international financial disaster, hobby rates were already at zero, so there were limits to how much more the Fed could push the financial system. One solution was to telegraph its intention to keep hobby rates low unless the financial system bought more aggressively, a strategy known as forward assistance. The forward cues meant that markets could spend at low cost in the long term, helping to keep the stock market strong and personal loan rates low, although the Fed could not lower interest rates further.
At other times, this signaling didn't last long either. When the Fed began raising prices in 2004, the domestic debt rates for most sectors actually became more flexible. From June 2004 to September 2005, both corporate bond yields and personal loan charges fell by about half a percentage point, while the Fed's main cost of activity increased from 1% to 3.75%. The markets didn't understand, and as a result, the Fed's efforts to graduate the economic system and make the growth of the 2000s more sustainable were a failure. This failure undoubtedly made the recession of the global fiscal crisis much worse than it would have been otherwise.
What we have here is a failure to speak.
Currently, the Fed and other relevant banks are trying to tell markets that they intend to tighten policy to control inflation. The result, in theory, is a cooling economic system and lower prices. But instead of guiding markets with beneficial readability or ambiguity, the Fed has given them a great deal of help from misunderstandings and contradictions this summer. Powell and different FOMC members have made statements that are either mutually unique or extremely distinct from outdated communications. This has allowed for a deadly divide between what the Fed wants and what the markets anticipate. Even sorting on a curve, this summer saw some stunning communication errors that indicate the need for reflection on the method of communication.
Let's take, for example, the June FOMC meeting: despite the Fed signaling for weeks that it planned to raise prices by 0.50%, the Wall Street Journal reported days before the meeting that the FOMC had changed its plan to raise rates by 0.75% instead – the largest rate hike at a meeting since 1994. In explaining the unexpected change, Powell pointed to a single poll that warned that Americans' expectations for future inflation were too excessive for consolation. However, this poll had a sample size of only a few hundred people and was later revised, proving to be a false alarm.
Powell has shifted which measure of inflation the Fed is watching more closely: core inflation, which includes items that have volatile cost changes, such as energy and food, or core inflation, which eliminates those categories in an attempt to measure underlying rate pressures. At the June meeting, Powell responded to a question about which inflation rating the Fed would focus on with a definitive “inflationary capacity inflation.” However, a month later, as gasoline costs and meal expenses began to fall again, Powell advised and stated that “core is basically a much better indicator of the bond and all inflation going forward”—the opposite of the position he took at the outdated meeting.
Irritated market observers will undoubtedly roll their eyes at anyone who is disgruntled when Fed officials speak from either side of their mouths. But these same grey-haired market observers were apparently puzzled by Powell's prepared remarks at the July FOMC meeting, when he noted that “it will probably be appropriate to slow the pace of increases” in activity rates. It is indeed a logical observation that the fastest pace of tightening in decades will not continue indefinitely. However, by stating this explicitly, Powell gave markets an opening to assume much more.
These slippers led to chaos in the markets. Equity spending plummeted after the mid-June meeting, but surged after the subsequent meeting seemed to signal that, essentially, the most intense price increases were over. The yield spread between harmful and low-chance bonds also collapsed. This sounds like good news, but it actually represents a disruption in how fiscal policy is channeled into easing the economic climate.
To correct the market assumption that the worst of the price increases was in the past, Powell and other FOMC members spent weeks trying to persuade traders that they were, nevertheless, committed to raising prices to keep inflation under control. At the annual economic coverage symposium in Jackson Gap, Wyoming, in August, the chairman attempted to reverse the jubilant market movement of late July and early August, sternly reminding his audience that curbing inflation would require the Fed to “transmit some pain” to the economy.
This is by no means to claim that all markets have not followed the Fed's lead. Two-year advance yields, which roughly approximate market prices to the federal monetary policy rate 12 months ahead, have risen frequently. While there have been ups and downs, the transition from a rate of less than 0.75% at the end of the last 12 months to almost 4.% today has been remarkably smooth and steady. However, the orderly circulation of Treasury securities, compared to the ongoing chaos in stocks and corporate bonds, underscores the Fed's inability to deliver on its plans.
The good news is that the bond market is confident the FOMC will prevail in curbing inflation, and consumer and agency surveys suggest inflation expectations have fallen with fuel spending in recent months. The Fed is ultimately credible, but the FOMC is making its own existence much more difficult by changing its script.
clarity primarily
There is a clear lesson for the FOMC this summer: communications don't seem to be working as they should. Specific forecasts or certain aspects of focus are being punished by volatility and unbalanced positioning. Far less conventional communication would serve the Fed intelligently.
Since I began tracking all publicly available comments from FOMC participants in June 2017, a Fed speaker has spoken publicly more than once a day – and that excludes Fed minutes and equivalent coverage or press release options. Powell also began giving eight press conferences on interest rate prices per year, twice as many as in 2018. If FOMC participants spoke far less, it could offer far less room for confusion.
The Fed has been served up in an organized manner time and again, publicly discussing its policy approach when it was no longer in a position to tighten abruptly. As the economic climate has shifted, so has the Fed's communication. Less is now more – and that should be enough to satisfy the goal of informing markets and the public without causing confusion.
George Pearkes is the global macro strategist for the bespoke investment community.
