The MacroTourist is old enough to remember when the Federal Reserve did not announce changes in monetary policy. Instead traders watched the Federal Reserve open market operations at 11:45am for signs the Fed Funds rate had changed. There was no forward guidance, no press conferences, just a Federal Reserve that dictated monetary policy through actual buying and selling in the market.
Somewhere along the way the academics at the Federal Reserve decided transparency was a better way to conduct monetary policy. I am sure they have stacks of “scientific papers” to justify their decision, but I don’t care. I don’t think ultra transparency at the Federal Reserve is a good thing, and in fact, I believe it is often counter productive.
Before you dismiss me as some grumpy old curmudgeon yelling at the kids to get off his lawn, let me walk you through my reasoning. All the theory about Federal Reserve transparency makes perfect sense on paper. Allowing market place participants to better understand FOMC board members’ thinking seems to allow for more efficient setting of monetary policy. It even allows Fed to affect policy without even intervening in the markets by guiding expectations of future moves.
It is wonderfully efficient, but herein lies the rub. Markets are discounting mechanisms. Through this religion of ultra transparency, the Federal Reserve (and most Central Banks throughout the world for that matter) cheapen their effectiveness. Fed policy is almost instantaneously priced in. Even large policy shifts such as quantitative easing see their effects wear off long before the program ends.
If this was the only problem with Central Bank transparency, then my complaints would be ringing a little hallow. But this discounting is tied to the central problem.
Fed communication affects the very conditions they are forecasting
George Soros was one of the first to speak about the problem of reflexivity in financial markets. Soros noted how actions of market participants affects the price of a security, which then causes a further confirming bias, leading to the security price moving even further in the same direction, only causing market participants to become more confident in their analysis, which causes the cycle to feed on itself. Market participants fail to realize their actions are affecting the outcome they are attempting to predict.
This reflexivity problem happens at the Federal Reserve on steroids. With every little bit of communication from FOMC board members, markets adjust interest rates and businesses alter their plans. The act of communicating their forecast almost ensures it will never happen.
A FOMC forecast of rising inflation with the corresponding increase in the Fed Funds rate causes the market to instantly reprice interest rates higher. Yet this repricing affects the economy. The economy is therefore subject to the higher rates of the forecasted inflation even before the inflation actually appears. This tightening of monetary conditions therefore causes the forecasted inflation to never materialize.
Other problems with too much communication
It probably comes as no surprise to Mrs. MacroTourist that I think the Fed focuses way too much on communication. Apart from affecting the very outcome they are forecasting, the FOMC also suffers from the problem it is a committee. There are twelve members, each with their own opinion about the economy and markets. Although market participants try to discern the various influence each individual board member has on Federal Reserve policy, inevitably it becomes a hodge podge of conflicting opinions. The action of the past month is a perfect example. The market’s perception of Fed policy has varied from “they are going to raise in April” to “they are on hold for the next year” as the different Fed officials’ speeches slid across the tape. The market’s interpretation of Fed policy has varied way more than actual policy during this period.
And those bloody dots… I don’t even want to start with the Fed dot plot. I guess the best comment about those dots is that average implied dot forecast doesn’t matter nearly as much as figuring out which dots are Yellen’s and Fischer’s. Is that really how the market should be forecasting Fed policy? By guessing the identity of each dots’ author?
PIMCO’s Paul McCulley once said the Fed needs to be “responsibly irresponsible.” He argued market participants need to be worried the Fed will overshoot otherwise they will simply discount the end of any stimulus.
Paul is absolutely bang on with this analysis. Think back to the three different instances of quantitative easing. The first two programs had fixed amount of balance sheet expansion. They worked for a period, but as soon as the program’s end was in sight, the market quickly returned to the previous deflationary bias. Although many investors were worried about inflation, the market realized once the Fed was finished, monetary conditions would no longer be expansionary.
It was only once Bernanke made the third QE program open ended did the market’s perceptions change. Although there was much hyperbolic talk about the coming hyper inflationary wave that would be the result of such an irresponsible program, the truth of the matter was that it never came.
You might argue in the long run it caused way more harm than good, but that is a story for another day. If the Fed’s goal was to break the deflationary mindset, this sort of aggressive open ended policy is what was required.
If the Federal Reserve continues to cap any worry about inflation breaking to the upside with all sorts of hawkish talk, then they are ensuring inflation will have all the more difficult time taking root.
All the members of the FOMC should just shut their traps and let the market interpret their actual interest rate moves. Nothing else is needed. And if they want to let us know those changes by 11:45am open market activity instead of a press conference, then that’s fine with me too…
The new poster child
I don’t usually comment on individual stocks, but I can’t resist on this Tesla madness.
I am sure you all know both the bull and bear story. I happen to think the price is stupid, but I understand the dream of a great story can keep a stock aloft for much longer than almost anyone could ever imagine.
Yet this dream needs cold hard cash to make the Tesla plants. I know the new model was a huge success and that hundreds of thousands of people forked over deposits to the new Steve Jobs replacement. But that won’t be enough money for Elon Musk’s Tesla. And with the stock running like it stole something, Musk is going to plug that demand like a butter tart. I don’t know when, but I would be extremely careful chasing TSLA up here. I would be shocked if there wasn’t a big massive equity issuance in the coming days.
Thanks for reading,