By Mike Dolan
LONDON (Reuters) – If the U.S. Federal Reserve’s plans are changing week to week, then the concept of “forward guidance” as a policy tool has been well and truly abandoned.
The latest of this year’s financial market quakes is a snapshot of how one of the three main monetary policy levers has been junked of necessity and, probably, by choice.
Just three months ago on March 4, Fed chief Jerome Powell told reporters that an outsize interest rate rise of 75 basis points was not something the central banks’ policy committee was “actively considering” as part of its planned series of rate hikes to rein in 40-year high U.S. inflation.
Yet, markets this week feel they have been pushed at the last minute to assume the Fed will indeed deliver its first three-quarter-point U.S. rate hike since 1994 on Wednesday after a slightly bizarre series of events following Friday’s news of a surprising acceleration in consumer price inflation last month.
While interest rate and bond markets were jolted somewhat by the inflation numbers themselves, Fed officials were in their traditional “purdah” period of pre-meeting silence.
But all hell broke loose when the Wall Street Journal’s Fed watcher Nick Timiraos on Monday reported that Powell and Co would in fact “consider” a move of 0.75% this week – contrary to another piece he wrote at the weekend.
The entire fixed income complex heaved and was forced to reprice an entirely new and elevated Fed trajectory from this week out to a peak of some 4% peak rates by March of next year. Stock markets nosedived worldwide and the dollar surged.
Among others, Goldman Sachs economist Jan Hatzius instantly changed the bank’s forecast to assume a 75bp move in Fed rates this week and next month – citing the WSJ article as the off-the-record “hint from the Fed leadership”, Friday’s inflation print and accelerating household inflation expectations.
Whatever the outcome later, the last minute guessing game and jumpy decision making – assuming the Fed was involved at all – is a stark departure from years of “forward guidance” designed not to shock markets, enhance transparency and allow investors months or years to absorb changes in policy tack.
The implication for investors is that Fed deliberations and those of other central banks will become far less predictable over the coming months and possibly years – implying greater uncertainty and volatility are on the horizon and will require higher risk premia to compensate.
As short and long term U.S. Treasury yields soared above 3% on Monday and the recession harbinger in the 2-10-year yield curve inverted again, the MOVE index of Treasury volatility staged its biggest one-day jump since the seismic March of 2020 when the pandemic hit and now stands at its highest since 2009.
And the still-negative “term premium” – which suggests investors demand no additional compensation for holding long-term bonds to maturity compared to rolling short-term bonds for the same period – may be next to give way as the Fed unwinds its gigantic balance sheet of bonds over the next year.
GRAPHIC: Yield Curve Inverts as Implied Fed Rates Peak Hits 4% (https://fingfx.thomsonreuters.com/gfx/mkt/akpezlgbjvr/Two.PNG)
GRAPHIC: US bond volatility, yields and term premium (https://fingfx.thomsonreuters.com/gfx/mkt/zgvomdwozvd/One.PNG)
‘OVER-TIGHTENING’
With many now wary of what the Fed new economic forecasts will reveal this week, the old phrase “data dependent” crops up once again and again.
That’s pretty benign ordinarily. But given some of the extreme economic distortions due to the pandemic reboot and war in Ukraine and related uncertainties for energy and good prices, that could lead to some wild recalibrations ahead of what the Fed and other central bank will be thinking from month to month.
Pictet Wealth Management’s Thomas Costerg reckons the Fed’s reaction function has becoming “backward looking”, panicked about past high inflation and prone to political pressure.
Pimco economist Allison Boxer also thinks 75bps is now possible this week and feels the Fed will keep hiking beyond September – creating a “serious risk of over-tightening”.
But “forward guidance” long into the future has been heavily criticised by many economists as a reason why the Fed and other central banks were so slow to normalise interest rates as economies recovered from the pandemic and inflation surged last year. Parking it for a bit may be deemed necessary.
Forward guidance as a quasi-formal policy instrument has only really been codified over the past 15-20 years as another way for central banks to affect long-term borrowing rates and market expectations – mostly over the past decade when key rates had run out of road near zero while deflation still lurked. It acted as a complement to bond buying as a means to retain traction on long-term rates.
The polar opposite was true as recently as the early 1990s. Not only did the Fed play its cards close to its chest, it often took more than 24 hours reading the runes of open market operations to figure out if policy had changed at all.
Keep them guessing was also a mantra across the world. Insiders at Germany’s Bundesbank used to advocate telling markets clearly how they formulated policy but “not what we are going to do tomorrow”.
With the deflation risks and “zero lower bound” problems of the past decade gone for now, guiding markets on interest rate rises is almost a novel undertaking.
And yet the early throes of Fed forward guidance during the tightening cycle of the early 2000s – when two years of well-flagged quarter-point rate rises brought policy rates from 1% to 5.25% by mid-2006 – were also blamed for suppressing volatility and spurring excess risk taking that seeded the 2007/2008 crash.
Should it guide clearly on long rates but not policy shifts?
With an unwind in the Fed’s balance sheet also now in the mix, the Fed may see some trade off between the two to manage a very bumpy ride ahead.
The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own
(by Mike Dolan, Twitter: @reutersMikeD. Editing by Jane Merriman)
