Crossed signals over Fed’s stimulus efforts

The Federal Reserve’s new communication strategy was supposed to make it easier to decipher the intentions of the famously secretive institution.

Markets, however, seem to have missed the memo.

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Investors increasingly have focused on predicting the moment the Fed will start to pull back on its massive stimulus program, causing more volatility in stocks and bond markets. Could it come as early as this week, when the central bank’s policymaking committee meets in Washington? Or will the Fed wait until the end of the year, when the fiscal drag is expected to have run its course? Will it make the announcement with a news conference or forge ahead with little explanation?

It is the type of parlor game the Fed had hoped to avoid. Instead, it has tried to convince the markets that the date is less important than the data.

Fed officials deliberately chose not to attach a time frame to their easy-money policies when developing their forward guidance for the public last year. Instead, for the first time, the Fed formally linked its decisions to the health of the economy: Interest rates would remain near zero, at least until the unemployment rate hit 6.5 percent or inflation reached 2.5 percent. And the Fed would keep pumping money into the recovery until there was “substantial improvement” in the job market.

The goal was to help investors come to better conclusions on their own by revealing the public data that Fed officials use as guideposts. In theory, that means interest rates will hew more closely to incoming data than to Fed pronouncements.

But, as it turns out, there are many ways to parse the numbers.

For example, the unemployment rate could fall to the Fed’s threshold of 6.5 percent because more workers are finding jobs. Or, it could fall because more people are giving up looking for work and leaving the labor force altogether. Those two scenarios would probably prompt very different responses from the central bank.

The numerical guideposts for the path of the Fed’s $85 billion a month in bond purchases are even foggier. Officials have not defined what “substantial improvement” in the job market looks like, though individually they have pointed to factors such as private-sector hiring and the number of people who voluntarily quit their jobs.

“They kind of threw out these conditions,” said Michael Feroli, chief U.S. economist at JPMorgan. “They’re telling us something but not telling us something.”

Those crossed signals carry significant consequences. Fed communications help shape investors’ expectations for monetary policy and the trajectory of the economy. Those expectations alone can influence a variety of interest rates that ultimately affect everyone from hedge fund managers to home buyers.

Confusion over the Fed’s plans has kept stock markets jittery in recent weeks, with the Dow Jones industrial average swinging nearly 300 points one day on central-bank speculation. Yields on 10-year Treasurys have risen to their highest level this year, at nearly 2.2 percent, amid worries that the Fed will begin to pull back its stimulus sooner rather than later. Meanwhile, rates on 30-year fixed mortgages have crept back up to almost 4 percent for the first time in the past year.

Part of the problem has been muddy economic data that do not provide a clear signal of where the recovery is headed. The Fed also has left itself plenty of wiggle room to interpret the data.

In fact, there is an unusual level of disagreement even among top Fed officials over how to read the economic data and what that means for its stimulus efforts, rattling markets even more.

The Fed is led by a board of seven governors based in Washington and 12 reserve bank presidents from districts across the country. The influential policy-setting committee consists of the governors and a rotating cast of four reserve bank presidents. For decades, open disagreement among officials was frowned upon under the tight leadership of Alan Greenspan.

Chairman Ben S. Bernanke, on the other hand, has welcomed debate among members as part of the central bank’s move toward greater transparency. That has given them more opportunities to influence the market, for better or for worse.

San Francisco Fed President John Williams interpreted the recent data as showing a rosier economic picture that could allow the central bank to begin dialing back its monthly bond purchases as soon as this summer. St. Louis Fed President James Bullard is less confident about the recovery but suggested bond purchases should continue because he is worried about the data on inflation. New York Fed President William C. Dudley said any reductions will be made slowly and carefully, while Richmond Fed President Jeffrey Lacker said the central bank should stop the program right away, cold turkey.

“It creates this background of inconsistent messages,” said Lou Crandall, chief economist at the research firm Wrightson ICAP. “The longer we’ve got to live with this constant drumbeat, the worse it’s going to get.”

Even Bernanke has gotten caught up in the dating game. In prepared congressional testimony last month, the chairman warned of the dangers of ending the Fed’s stimulus efforts too early in the recovery. But when pressed by lawmakers, he acknowledged that the Fed could begin to reduce its bond purchases in its next few policy meetings.

Bernanke has tried to cast any reduction as less stimulus, but that would not necessarily mean the Fed is ready to take its foot off the gas pedal. Markets do not seem to be buying the line. Official Fed communications have tried to emphasize that the central bank has the flexibility to respond as economic data roll in, and the policy statement slated for release Wednesday is likely to make the same point.

The question remains whether the markets are willing to listen.

“This kind of flexibility means more uncertainty,” said former Fed governor Larry Meyer, who now heads the consulting firm Macroeconomic Advisers.

 
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