Let's Talk About the Fed's Communications Problem
The Federal Reserve appears to have a communications problem -- and it’s not just the central bank’s confusing and contradictory signals about dialing back quantitative easing.
In addition to the tapering mess, some are concerned that a slew of looming personnel changes at the Fed are compromising its ability to effectively communicate future policy moves to an increasingly-skeptical market.
“The Fed that gives the forward guidance will not be the Fed that implements it,” Marc Chandler, global head of currency strategy at Brown Brothers Harriman, wrote in a note this week.
On top of the much-talked about retirement of Fed chief Ben Bernanke, the central bank is bracing for an unusually-large turnover in the coming months. At least four of the seven seats on the Fed Board of Governors will need to be filled next year as well as a vacancy at the top of the Cleveland Fed.
Why should Wall Street believe the Fed’s promises on interest rates if the ones making the promises won’t even be around to execute them?
“The Fed’s communication is muddied, its future leadership is uncertain, QE remains in place, and the Street is confused,” David Joy, chief market strategist at Ameriprise Financial (NYSE:AMP), wrote in a recent note.
‘Coin Toss’ Fed Policy?
Even before considering the personnel turnover, the Fed’s communications efforts have come under fire due to the central bank’s surprising decision not to dial back on QE, the $85-billion-a-month bond-buying exercise aimed at boosting the economy.
Driven by strong hints from Bernanke and many other policymakers, 64% of investors polled by Barclays (NYSE:BCS) earlier this month believed the Fed would “taper” QE at last week’s meeting. Almost 100% expected tapering to occur before the end of the year, which now may not happen.
The September 19 decision not to scale back asset purchases shocked Wall Street, sending the Dow Industrials surging 147 points to an all-time high after the announcement.
The closely-watched yield on the 10-year Treasury plunged to 2.706% that day, from 2.85% the day before. The 10-year yield has since eased further, dropping to a six-week low of 2.65% on Tuesday.
Interestingly, the Fed cited rising interest rates, which had been bumped higher by expectations of a taper, as one of the main reasons to hold off.
Some market participants believe the Fed’s handling of this matter may have caused it to lose some credibility among investors about its monetary policy intent.
“Federal Reserve policy is now officially a coin toss,” Michael Block, chief market strategist at Rhino Trading Partners, wrote in a note.
Others note that the Fed never explicitly said it would dial back on QE no matter what in September.
“I don’t think credibility is all about saying we’re going to do this come hell or high water. If circumstances change, you ought to change your mind,” said Edwin Truman, a former Fed official.
Host of Open Seats to Fill
But it’s becoming increasingly difficult to gauge how the Fed will react to future economic conditions because it’s not entirely clear who will be running the ship in the coming quarters.
Perhaps that helps explain part of the reason why the “no taper” decision caused such a fleeting rally on Wall Street. After the initial buying binge, U.S. stocks, which many believe were addicted to QE, are in jeopardy of their first five-day losing streak of the year.
The race to succeed Bernanke, whose term expires at the end of January, has become increasingly politicized.
Lawmakers and economists who opposed the candidacy of Larry Summers vocally pushed President Obama to select Janet Yellen, the Fed vice chairman.
Yellen once again looks like the front runner, although if she were passed over it’s likely she would step down from the Fed, creating a fifth vacancy.
"This is just an awkward time where the Fed is transitioning itself at the same time they want to transition policy."
Another Fed governor, Sarah Bloom Raskin, was nominated in July to become deputy secretary of the Treasury Department.
Fed Governor Elizabeth Duke departed at the end of August, while the term of Jerome Powell, a Republican who took office in May 2012 as part of a compromise, is set to expire at the end of January.
Plus, last month Cleveland Fed President Sandra Pianalto announced her early 2014 retirement.
“This is just an awkward time where the Fed is transitioning itself at the same time they want to transition policy,” said Chandler.
Discounting Forward Guidance
Chandler and others believe the Fed’s forward guidance, which indicates the expected path of monetary policy in the future, may be compromised by this personnel turnover.
As the central bank unwinds QE, policymakers will have to lean on this guidance as a way to assure investors monetary policy tightening isn’t occurring too slowly or too quickly.
“Forward guidance language can put downward pressure on longer-term interest rates and thereby lower the cost of credit for households and businesses, and also help improve broader financial conditions,” the Fed said on its website.
For example, the Fed said in December 2012 it expects interest rates to remain exceptionally low as long as unemployment remains above 6.5% and inflation projections remain at no more than 2.5%.
The leadership change “has to cause some discounting of the forward guidance because they can’t really commit for their successors,” said Jeffrey Shafer, a former Fed official and ex-undersecretary of the Treasury. “The people who are there now aren’t going to be there next year.”
Of course, this personnel uncertainty could be removed if the White House and U.S. Senate swiftly move to nominate and confirm replacements for Bernanke and the other Fed governors.
If the baton is passed to Yellen, Fed policy may very much stay the course as the former San Francisco Fed bank president is a reliable dove.
Truman, a senior fellow at the Peterson Institute for International Economics, said, “You’re not going to find much in the way of dramatic changes of the basic trajectory."