Fed Policy: It Depends Upon The Data

Two keystones to current FOMC policy are transparency and effective communications. Both have taken a hit last week. Chairman Bernanke’s testimony before Congress did little to clarify how long the FOMC will pursue accommodative policy, what will cause it to begin to phase out its asset purchase program, or how that phase-out will proceed. This testimony, along with statements from Federal Reserve Bank presidents, didn’t set well with markets, as was demonstrated in Friday’s WSJ. Bernanke’s observation that the pace of asset purchases or sale would “depend upon the data” didn’t bolster confidence that the FOMC had a well-defined set of criteria for when and how to act.

We did learn that it was now unlikely that MBS sales will figure in its exit strategy due to concerns about potential disruptions to the mortgage and housing markets. But this means that the burden will fall on the Treasury component of the Fed’s balance sheet, with the obvious implications for interest rates at the long end of the curve because of the predominance of long term Treasuries in the Fed’s portfolio.

We also learned a bit about the evolution of that strategy, not from testimony or speeches but from the minutes of the last FOMC meeting released last week. Following the policy decision discussion the minutes included a section entitled “Review of Exit Strategy Principles” which was a summary of Committee discussion of what if any changes might be made in the exit principles it had published in the minutes of its June 2011 meeting.

The minutes noted specifically that while the broad principles were still applicable events, especially the asset purchase program, warranted revisiting some of the nuances of possible strategies. Interestingly, there is a comment in this section that “…because normalization still appears to be far (emphasis added) in the future, the Committee might wish to wait and acquire additional experience to inform its plans.” This comment seems to be at odds with the views of those expecting action relatively soon, because the statement suggests the FOMC is far from settling on a firm strategy. The implication was that there might be a lot of “learning by doing” when policy is changed. There was also a tantalizing hint that some participants think that in the future the Federal Funds rate may not be the best instrument for conducting policy, and that alternative instruments might be better employed. As always the response to such suggestions was the call for further research on new tools.

Finally, the discussion turned to whether the FOMC should simply acknowledge that events since June 2011 may have overtaken the policy strategy contemplated at that time and that the principles needed to be revised. Indeed, the question was whether or not to issue revised principles. But doing so might risk the public concluding that the Committee was not only prepared to act but also had the tools and plans in place to normalize policy. To that end, rather than revising the principles, the Committee agreed to do more preparatory work for consideration in the future. Note that the “future” did not mean the next meeting.

Reading between the lines of this segment of the minutes suggests that the Committee has not yet settled on what the best course of action might be when changing either its asset purchase policies or what the relationship might be between shutting down its asset purchases and actually beginning to back off from its extraordinary monetary accommodation. Finally, the Committee is still struggling with how best to communicate and provide forward guidance when it comes to either the asset purchase program or its accommodative policy. If the committee is unsettled, it is not surprising that markets and the public are unsettled.

In the face of such uncertainty, the challenge for investors is to not only to try and guess when and how the FOMC will act, but also to guess what market responses policy changes might elicit. Assuming that the asset purchase program is tapered off first, markets are likely to react abruptly rather than in the gradual way the FOMC hopes. Here too is where the rubber hits the road in terms of the FOMC’s communications strategy and the provision of forward guidance. Chairman Bernanke has hinted that the pace of either assets sales and/or possible additional purchases will depend upon incoming data.

But how does one communicate forward guidance that markets can plan around when the answer is that policy “it depends on incoming data?” That is not useful forward guidance and will only likely heighten uncertainty and greater market volatility. But what is one to do? No fixed income investor wants to be left holding a portfolio of long term bonds whose values are likely to change in unpredictable ways. At the same time, while equity markets have been buoyed by QE, the thought that it is ending will be a negative for equities.

In other words, one likely scenario is a short term shock to both equity and fixed income markets to be followed by a period of adjustment and volatility. The duration and path of that adjustment will depend critically upon the FOMC’s reaction function to events that it observes and the kind of forward guidance it offers. What we are guessing is that without a plan it becomes difficult to provide clarity in communication intended to allow markets re-pricing of assets in a rational way. Hence, lack of clarity will only exacerbate volatility and cause markets to misbehave. The Fed may be making its own job harder by not facing up to the fact its perception of clarity may not match the market’s perceptions.

BY Bob Eisenbeis