Does the Fed have a communication problem, or do markets have a listening problem?

September 23, 2013
What we have here is a failure to communicate. (AFP PHOTO/KAREN BLEIER)
What we have here is a failure to communicate. (Karen Bleier/AFP)

Hop in your time machine and set the dial for, say, this past April. Once there, call up any of the smarter people who make their living analyzing what the Federal Reserve is doing, and ask them two questions: How much bond-buying will the Fed be doing in the fall, and who will be the next chairman of the Fed?

Their answer back in April would have been "$85 billion a month" and "Janet Yellen." Those answers now look correct. But the voyage from there to here has been a doozy.

First, Chairman Ben Bernanke and his colleagues telegraphed that they would begin slowing their bond buying later in the year, which markets interpreted as meaning at their policy meeting last week. Until, that is, 2 p.m. last Wednesday, when "Taper Off!" was shouted on trading floors around the world and global markets rallied on news that the Fed would wait longer.

The path toward a successor for Bernanke has been even rockier, with the White House signaling over the summer that the president was inclined to nominate Larry Summers, until this month, when opposition from key senators led him to withdraw.

The latter situation was a messy communications problem brought to you by the Obama administration, not the Fed itself. But on the question of monetary policy, that's all on the shoulders of Bernanke & Co.

So did the Fed blunder its communications in the runup to the meeting? Or did Wall Street fail to listen? And either way, what does it mean for the future of the economy and monetary policy?

The answer from the world of analysts and Fed watchers is resounding: The Fed blew it. In a Reuters poll, 33 of 48 forecasters described the Fed's communications as "unclear," with one of them anonymously describing it as "buried under a pile of horse dung." Less colorfully, as Justin Wolfers put it at Bloomberg View, "This whole taper debate is . . .  the result of a failed communication strategy."

Three things happened since the Fed first signaled that a taper was on the way in June. Interest rates spiked, which threatens to slow future growth (in Fedspeak, financial conditions tightened). The risk of a damaging fiscal showdown heightened. And the economic data has been soft, with job growth, if anything, decelerating.

As these trends came into focus between June and September while  the Fed was keeping quiet, giving no definitive signals as to how its thinking was evolving. The July policy meeting (and subsequent minutes) came and went without any sign that the Fed was backing off of its plans. Bernanke did not give his customary speech at the late August Jackson Hole conference sponsored by the Kansas City Fed. Indeed, none of the seven Fed governors gave a speech between July 17 and Sept. 20, the longest period of such silence to be found in records that go back to 1996, the Wall Street Journal found.

Meanwhile, the most recent guidance that Bernanke had given was rapidly being overtaken by events. The chairman had said in June, when the unemployment rate was 7.6 percent, that the policymakers expected to end their bond-buying program entirely, roughly when unemployment was down to around 7 percent. Well, we're almost there already; joblessness was 7.3 percent in August. If recent trends continue, it will be down to 7 percent around the end of the year — even though the Fed has no intention of stopping its QE programs at that point, and may not have even started slowing them.

So add it all up, and the Fed seems to have made three big mistakes: First, setting a threshold for action (the 7 percent number) that they didn't really believe in (the Fed is now effectively backtracking from it just three months later); second, in underestimating how much their own signaling at the June meeting would cause higher longer-term interest rates and thus undermine the case for slowing bond purchases in September; and third, in keeping quiet during a long stretch in which expectations were solidifying in markets that the day of tapering was upon us.

Ironically, in their communications since the meeting, Fed officials have explained all this much better; read New York Fed president Bill Dudley's speech Monday at Fordham University, for example.

On one level, none of this matters a great deal. Yes, markets were surprised by the Fed decision last week, which created a bit more volatility than was absolutely necessary. Who cares, right?

But one of the fascinating things about monetary policy is that communications IS policy. In other words, markets interpreted a possible move by the Fed to slow their bond purchases from, say, $85 billion to $65 billion at the September meeting as conveying important information about the entire course of policy over the next several years. Last Tuesday, futures markets priced in a 45.6 percent chance that the Fed would increase short-term interest rates from their current near-zero levels by December 2014; following the meeting Wednesday, that plummeted to 35.6 percent.

Fed watchers have become spoiled at the sheer volume of information the Fed now conveys about its actions. Detailed policy statements, forecasts for economic variables and future interest rates, news conferences — these are all new innovations in the past six years. It's a far cry from the not-too-distant past, when investors had to try to figure out what the Fed would do by scoping out the thickness of Alan Greenspan's briefcase.

In other words, now that we can see more of the inner workings of Fed policymaking, we see the reality: They're making it up as they go along, like the rest of us.

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Timothy B. Lee · September 23, 2013