FOMC Surprise

September 18, 2013

It’s a nice precedent to see that the Federal Open Market Committee doesn’t feel boxed in by the market’s interpretation of previous Fed cues regarding what it may or may not decide at a forthcoming policy meeting.  In fact, markets did not get a nuance that the FOMC has always maintained since forward guidance was introduced.  Forward guidance merely points out what Fed officials think they are likely to do in the future.  Actual decisions will be modified by shifts in data trends and other developments that affect the Fed’s baseline view of the most likely future and possible risks surrounding that forecast.  Things changed between the first hint last May that a scale-back of quantitative easing might occur as soon as September.  There were even significant changes since the FOMC met in late July.

  • Long-term interest rates reacted more sharply to the Fed’s tapering talk than central bank officials had anticipated, and the authorities became concerned that rates would jump much further if tapering kicked off now.  A bigger worry is that higher long-term interest rates would depress growth, not only below their baseline scenario but below acceptable boundaries. 
  • Analysts had realized that U.S. data trends in a variety of areas — jobs growth, corporate earnings, and housing figures, for example — had veered somewhat below what was assumed, but the feeling prior to this week’s meeting had been that policy was in fact being governed by a hidden agenda, namely mounting fear that quantitative easing was sowing new asset bubbles and creating other financial market distortions. For now, at least, those worries failed to trump misgivings that the U.S. economy couldn’t handle a tightening of monetary policy just yet.
  • It’s possible, too, that today’s decision was influenced by a desire not to be overly predictable and by the dynamics of a committee whose membership will be changing extensively in 2014.  What legacy did the current FOMC wish to leave its successor.  There are worse mistakes than doing something mainly because it’s what others expect.

My main takeaway from today’s statement and press conference is that Fed policy will change no more quickly than the U.S. economy is able to handle lessening stimulus.  A great mistake of Bank of Japan policy in the past two decades was that economy’s failure to handle BOJ attempts to raise interest rates.  Japan as a result experienced both weak growth and too low inflation despite having the developed world’s worst public finances.  The outlook for the U.S. economy is not a mirror of current economic trends.  Monetary officials have to also consider what’s happening to interest rates and to anticipate how that might impact the economy in the future. 

One lesson of today’s decision is that markets mustn’t boost long-term interest rates more than officials think is appropriate.  If the collective market response to Fed policy guidance exaggerates what monetary officials believe to be consistent with what compelled them to drop such hints of tightening, investors must also understand that their own reactive behavior may invalidate the cues.  When markets get it right in the first place, they will be rewarded.  That’s easier said than done and not the fault of individual investors.  Alas, it is in the nature of markets — and all collective behavior — to overstate individual behavior. 

A second lesson of today’s decision is that for the present FOMC membership at least, the desired appropriate first increase of the Federal funds rate is much further away in time than the central bank’s critics like John Stockman, Rand Paul, or any number of investors want.  The vast majority of FOMC members favor not changing the Fed funds rate before 2015, and ten of seventeen predict the rate will be no higher than 2.0% at end-2016 versus a view that long-run equilibrium lies at 4%.  Bernanke has amazingly good credentials as a monetary economist and analytical thinker.  Decisions like the one made by the FOMC can’t be reached with full command of all pertinent facts, so mistakes are always possible.   Thank goodness the chairman has the self-confidence and courage to trust how extensive training and experience guides him and not to listen to other self-proclaimed experts like Stockman, who with an undergraduate degree in history and some graduate work at divinity school tell us that they know economics better than the chairman.  Credentials matter.



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