Defining Fed Policy and What to Expect from the Dollar

September 29, 2015

A succession of changes occurred starting in the early to mid-1990s in how U.S. monetary policy is communicated to the public.  What the Fed was doing and why became much more transparent.  Policy was extremely opaque a generation ago –no minutes, no forward guidance, no immediate FOMC statement explaining a change, no post-meeting press conferences, no forecasts of macroeconomic data, and no indication of the range of interest rate expectations among policymakers. Changes in the stance of policy were not limited mostly to scheduled meetings.  They still can occur anytime, but back then, inter-meeting changes were not nearly the rarity that such are today.  When policy changed, it took close analysis of daily Federal Reserve money market operations for the public to discern that the stance had been modified, and it could take some time to figure out that a change rather than special factors had occurred. 

A push for transparency was undertaken as policymakers came to believe that policy characterized by more predictability and consistency and less shock and surprise would actually enhance the effectiveness of policy in terms of producing the market reactions that policymakers sought.  Transparency became an even more valued dimension of policy during the banking crisis last decade, since it enabled the central bank to exert control not only over short-term interest rates but also over longer-rates through forward guidance that laid out the most likely future path of Fed decisions that officials themselves believed to be the case.

Policymaking has now moved into a new era of indecisiveness.  This is not the explicit fault of Chair Yellen or of her highly qualified team of colleagues.  The challenge has become more nuanced to Fed officials and other central bankers as macroeconomic trends have progressed to a point of transition.  It’s much less obvious how the Fed should proceed.  Fed watchers therefore need to think like a central banker and understand how policy will be forged over the coming year or two.  Fed officials have given many clues.  They have a dual mandate to maximize employment but also to secure and steer a 2% rate of inflation defined by the PCE price deflator.  Policy decisions will be guided mostly by what the Federal Open Market Committee expects to happen to employment growth and inflation given all the information at its disposal.  Members do not target market prices like a stock index, a longer-term interest rate, or the dollar, but all of these variables come into play to the extent that such influence the future course of employment and inflation.  Market volatility per se needn’t be a game changer unless such modifies the baseline forecast of the mandated macroeconomic targets.  The same is true regarding external developments like trends of other economies, movements in foreign exchange, and commodity costs set in world markets.  While policy is ultimately based on expectations, information is in fact received with lags of varying length, and the impact of monetary policy changes is felt with long and variable lags.  Inflation these days is determined much more on a global basis than from strictly domestic developments, and policymakers attempt to make decisions intended for the future based on information collected about the past-to-present. 

Policymaking inevitably has to be a very complicated and highly dynamic process.  It shouldn’t be put on auto-pilot, and transparency has a dark side that becomes especially toxic at turning points like the present.  The signals broadcast by the Fed through its range of communications are stochastic and simply not continuous enough to impart the market with the knowledge that any one FOMC member might have at a given point in time, let alone the group as a whole.  So there is plenty of scope for misinterpretation from all this transparency, and it wouldn’t be the worst thing in the world to revert to the opacity of old.  Let the market know the goals and all the information that policymakers know.  Inform the market that policy will be decided in such a way that gives the economy the best chance of achieving those goals while minimizing the probability of a major policy error.  But allow market players to collectively go through the same exercise as Fed officials rather than focus upon what officials are believed to be predisposed to do.  As one example, cut out the myriad of speeches by Fed authorities that tend to throw out conflicting signs.

As I indicated in a blog post from two weeks ago, conditions for embarking on U.S. rate normalization are currently less straight-forwardly favorable than at the beginning of the previous four interest rate tightening cycles.  This no doubt is understood by many FOMC members, which explains the group’s hesitation so far.  But the preponderance of assertions that the program will begin before end-2015 very strongly points to a hike either in October or December, barring a decisive turn for the worse in the U.S. economy.  That hasn’t happened.  Third-quarter GDP and the latest signals of household confidence attest to a resilient consumer sector in spite of the considerable market volatility during the third quarter.

Market volatility has been generally much greater than trend movement.  Take foreign exchange.  During September, the U.S. currency traded in high-low ranges that exceeded 5.0% for the Aussie and New Zealand dollar, 3.0% in the cases of sterling, the euro, Swiss franc and loonie, and 2.0% in the yen.  But the dollar is ending the quarter very close to its high-low midpoints in the case of the euro, yen, Swiss franc and kiwi, and it’s net moves since the end of August are less than 1.5% vis-a-vis all the above relationships except the Canadian dollar which shows a loss of 1.9%. The 10-year Treasury yield’s decline this month of 15 basis points is less than comparable drops in German bunds and British gilts.  10-year sovereign debt yields have slipped less than 10 basis points in Switzerland, Canada, Australia and Japan.  The direction is sensible since inflation in most countries hasn’t bottomed amidst continuing subdued wages, labor market slack and falling commodity costs.  Janet Yellen has stressed that normalization will be gradual, and that guidance seems consistent with a landscape where deflation is a more formidable danger than inflation.  Sub-zero directional price movement has a positive probability and infinitely worse consequences than a rise of inflation above 2.0%.

A more worrying element of the volatility concerns equities.  Not only have share prices swung widely, but also there is a significant cumulating downward direction to the correction.  Chances are improving that such will evolve into a genuine bear market defined as a peak to trough drop of at least 20%.  The DOW is already down 13%, thus two-thirds of the way to bear status.  It’s dropping in spite of robust real GDP growth in the third quarter of 3.9% and in line with similar steep declines in most stock markets around the world.  Global growth prospects are still weakening and haven’t reached a seeming inflection point yet.  Following the policy-induced moon shot of stock prices from their March 2009 low, a drop of 20% does not seem surprising.  From a longer standpoint, U.S. share prices have advanced since mid-January 2000 — a span of almost 16 years — by just 2.0% per annum following value appreciation of 16.9% per year over the previous 17-1/2 years.  This speaks to a loss of dynamism in U.S. corporate earnings prospects.  That’s not surprising, either, given the scant growth in labor productivity and the very wide gap between the current level of jobs and the level where such would be if the trend over the last twenty years of the 20th century had persisted.  The perception of ruptured politics in the United States only adds to the picture that what lies ahead will be no better than the first 15 years of this century.  Be that as it may, wealth is being destroyed by share price implosion, and the 3.9% growth in the spring should not be trusted as a harbinger.

So how have things turned out in the early days of prior Fed normalizations?  Over the first three months of the last four Fed tightening cycles, which respectively started on March 29, 1988, February 4, 1994, June 30, 1999 and June 30, 2004, U.S. growth slowed in the first two instances but accelerated in the more recent two cases.  Ten-year Treasury yields barely moved in the earliest example and in the 1999 case, soared 103 basis points in early 1994, and fell 53 basis points in the third quarter of 2004.  The U.S.-German 10-year sovereign debt differential increased 63 basis points in the 1994 case but narrowed by between 26 and 65 basis points in the other three examples, thus theoretically giving the dollar greater interest-rate appeal. 

  • The dollar appreciated 9.6% against the mark and 6.6% versus the yen between March 29 and June 29, 1988.  The first and subsequent tightenings in 1988 were not formerly announced.  Two moves occurred at scheduled FOMC meetings, and three others were engineered by intermeeting operations.  Recall that the stock market crashed on October 19, 1987, and the Fed eased immediately in response.  When no recession ensued, policy switched gears quickly.  The lesson from 1987 is that every slump in share prices needn’t foreshadow a recession, although many do.  Fed officials wanted to wait a little longer at the September 2015 meeting in order to gain confidence that falling stock prices aren’t going to depress U.S. growth unduly.
  • Between February 4, 1994 and May 4, 1994, the dollar lost 6.7% against the yen and 5.3% against the mark even though U.S. long-term interest rates became much more attractive on a relative basis.  Over a year’s time, the federal funds rate would double to 6.0%.  While a recession was avoided, U.S. economic growth slowed very sharply between the last half of 1994 and the first half of 1995.
  • From mid-1999 to the end of the third quarter, the dollar slumped 12.3% against the yen and fell 2.9% versus the euro.  1999-00 was a weak period for the euro, which fell from $1.18 to a low of $0.8228 in late October 2000.  The point is that within a nearly two-year span of general euro depreciation, the initial quarter after the Fed began to raise its interest rate proved an exception to trend.
  • There was little net movement in the dollar between mid-2004 and end-September 2004 — just a 2.1% dip against the euro and a 1.5% rise versus the yen.

Interest rates, exchange rates, and the volume of capital flows are determined simultaneously in the marketplace.  There’s no absolute reason to expect a rising dollar as soon as Fed tightening commences.  It depends on what else is happening in the U.S. and abroad.  More often than not, the above results show that recent experience has in fact been just the opposite.  In the last three instances of U.S. rate normalization, the dollar started in reverse, not forward, gear.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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