Fed 'Clarity' Remains Inconsistent

“I shot the sheriff, but I didn’t shoot the deputy.” (Bob Marley, “I Shot the Sheriff,” 1973)

Fed (Federal Reserve) Chairman Ben Bernanke called himself “deputized” by the members of the FOMC (Federal Open Market Committee). His task was to deliver a message. Let’s put the message in plain English and talk about it.

The message was “We will keep buying $85 billion per month of Treasuries and agencies now. We will start to reduce those purchases by the end of this year and will gradually reduce those purchases to zero. Then we will stabilize things for a while and deal with raising the Federal Funds rate from its present level of 0 percent to 0.25 percent.”

The timing of that activity is subject to economic variables. We are assuming there is going to be accelerated economic growth. We are assuming that the unemployment rate will continue to fall. We are assuming that currently low inflation will remain low, but will not go lower. And we are assuming that the labor participation rate and other detailed labor force characteristics in the will continue to recover in some positive way.

IF those things happen in the outlined sequence; IF the FOMC and the composition of the Fed still have a majority view to support this policy; IF all of these sequential things happen without being impacted by actions regarding the federal government sequestration, tax policy, geopolitical risk, or other elements that could alter the mix; IF all that happens follows a perfect path, then around 2015 a new FOMC and new Fed chairman will face the task of gradually raising the targeted Federal Funds rate above 0.25 percent.

How and when the Fed will do all that still remains to be seen. All the “IFs” still have yet to happen. Today, this month, next month, and in the following months, the Fed will still be highly stimulative, adding new purchases to its balance sheet and targeting a policy change.

The short-term interest rate base tied to near zero remains in effect for at least another two years IF all the good things happen in a benign way.

Nobody knows whether or not things are going to happen in a benign way. History shows that volatile surprises come along, and when they do they alter forecasts and policy. Since this policy outlook based on optimistic economic recovery assumptions is patently inconsistent with the forecasts of the members of the FOMC who created the scenario I described and deputized the chairman to deliver this message, the inconsistencies have introduced additional risk premia into the market.

My colleague Bob Eisenbeis has written extensively about the inconsistency between the Fed forecasts collectively assembled by 19 members of the FOMC. He has also written about the position outlined by Chairman Bernanke, the “deputy” for all of those members.

Inconsistencies create risk premia.

What happened after the Bernanke/Fed meeting and communication? Did we get clarity? In our view, we did not. Did we get more obfuscation and confusion? In our opinion, we did. Markets thought so, too. Interest rates went up; measures of risk went up; and the market-based pricing of the risk of changes in Fed policies and the risk attributable to the inconsistencies went up.

What happened when these risk factors increased and markets fell? Positive wealth effects turned into negative wealth effects. Lower mortgage rates turned into higher mortgage rates. Decision making by entrepreneurs, activists, political officials in state and local governments, and all of the agents that have to depend on these policies in order to determine their future paths was ratcheted back.

The result of higher risk premia, higher interest rates, higher mortgage rates, and the attendant uncertainty introduced by policy inconsistencies can only be a slowing in the real economic recovery. If you have one set of risk premia, one path toward some stabilization in the future, and you alter it by raising the risk premia and destabilizing the path or adding wider bounds of uncertainty, you get economic slowing. Somewhere, someone is not going to buy a house when they otherwise would have done so. Someplace, some business is not going to hire someone when they otherwise would have. The Fed has faced its Rubicon, as we have described in our interview in the Wall Street Journal and in our writings. The Fed tried to cross it. The boat sank.

This is an opportunistic time for market agents. Bonds, especially tax-free bonds, are very cheap. The rate of inflation remains low and is trending lower. Look at the comments of St. Louis Fed President James Bullard when it comes to that question. He is properly worried about the inflation rate being too low and the deflation risk rising.

In the stock market, persistent zero-bound interest rates for the next two years in the US are bullish for US stocks. The recovery path in 2015, 2016, or 2017 will be gradual. It will be gradual whether or not the Fed chair is Janet Yellen; Roger Ferguson, Jr.; Alan Blinder; Timothy Geithner; or someone else. As for the composition of policy, the Bernanke policy doesn’t change. The communication, however, could be vastly improved. This was an attempt at clarity, but it conveyed inconsistent messages and failed in achieving that clarity. The “deputy” tried, but the FOMC didn’t clarify its position effectively enough. Maybe the revelation of the written minutes will add to clarity. Maybe Fedspeak will provide clarity over the course of the next month or until we get to the next meeting.

BY David R. Kotok