Transparency Has Failed the Fed

The V-shaped pattern in equity prices over the past several months shows how quickly and powerfully monetary policy decisions and pronouncements nowadays influence investor expectations and decisions. The dynamic feedback loop exposes the flaws of a transparent monetary policy and the speculative nature of the financial markets.

Proponents of a more transparent monetary policy argue that it promotes accountability and improves the effectiveness of policymaking as it eliminates the uncertainty about future direction of monetary policy. Yet, in practice policy transparency elevates the role of the financial markets, giving it too much “free” information to speculate and at times “veto” power over policy decisions. As such, policy transparency has not reduced systemic risks, nor has it made monetary policy more effective.

Following the decision to raise official rates by 25 basis points at September 25-26 FOMC meeting Federal Reserve Chair Jerome Powell stated that official rates were still accommodative and that policy rates were far from "neutral". Mr. Powell's statements were consistent with the policy rate forecast released at the September FOMC meeting as the consensus forecast of policymakers showed a modest rise in official rates to a little over 3% by the end of 2019. Nonetheless, the news of additional official rate hike triggered a negative shift in investor sentiment, a sharp increase in volatility, near-record equity withdraws, and a sharp decline in equity prices in the final months of 2018, which at its deepest point totaled nearly 20%.

The abrupt drop in equity price and the potential negative impact on the economy forced policymakers to rethink their plans on lifting official rates further. At first, policymakers offered repeated public assurances about adopting a “patient” approach and that was followed with a full pivot at the March 18-19 FOMC meeting as updated forecasts revealed that policymakers as a group were no longer anticipating raising official rates in 2019, reversing the call of two rate hikes made only three months earlier.

The financial markets tested policymakers to determine if the pledge to raise official rates, under all conditions, was credible or not. Policymakers blinked and investors cheered. In the first 4 months of 2019 the broad equity indexes have recorded gains of 15% to 20%.

This is not the first time the financial markets forced policymakers to back away from their plans to reduce the scale of monetary accommodation. In May of 2013 the Fed Chair Mr. Ben Bernanke floated the idea of cutting back and eventually terminating the asset purchase program later in the year. The reaction in the bond market was quick and sharp, evident by 10-year yields rising by over 100 basis points in a span of only two months. The rise in yields shocked policymakers, forcing them to rethink their plans, resulting in a full pivot as policymakers announced an extension of their asset purchase program at the September FOMC meeting.

Here too the financial markets tested policymakers pledge to lessen the scale of monetary accommodation, and when policymakers backed away the financial markets responded with powerful rally. Over the final 4 months of 2013, broad equity averages were up between 13% and 15%.

The events of 2013 and 2018/19 are different, but in both cases each one underscores the growing role of the financial markets in day-to-day monetary policy decisions and the lesser role policymakers attach to the underlying trends in the economy. It’s worth noting that in the third and fourth quarters of 2013 real GDP grew over 3% in each period and the initial estimate for Q1 2019 was over 3% as well.

Deferring the decision to become less accommodative every time the financial markets experiences a hiccup sets up a bad precedent as it “anchors” investors expectations to policy announcements and less so to fundamentals of growth and earnings. Policy transparency, with explicit targets on growth, unemployment and inflation, has made it more difficult to implement monetary policy. In 2008, policymakers were criticized for not giving enough attention to the financial markets. This time, policymakers could be criticized for giving too much attention and not realizing that by keeping official rates very low, often in response to adverse reactions in the financial markets, they are contributing to the buildup of risks in the financial system.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.