Economic Research:

The Market's Shocking Shock At The Fed's Non-Taper Shock

Credit Market Services: Paul Sheard, Chief Global Economist and Head of Global Economics and Research, New York (1) 212-438-6262; paul_sheard@standardandpoors.com

Table Of Contents
Overbaked September The Asymmetric Nature Of Monetary Policy Risks Tapering Backtracking Or Reality Check? Forward Guidance As A Double-Edged Sword The Limits Of Markets Serving Double Duty For Monetary Policy All Eyes On The Next Chair Related Research

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Economic Research:

The Market's Shocking Shock At The Fed's Non-Taper Shock

(Editor's Note: The views expressed here are those of Standard & Poor's chief global economist. While these views can help to inform the ratings process, sovereign and other ratings are based on the decisions of ratings committees, exercising their analytical judgment in accordance with publicly available ratings criteria.) The U.S. Federal Reserve shocked markets this week by not announcing a "tapering" of its open-ended, results-oriented program of buying $85 billion of longer-term Treasuries and mortgage-backed securities per month (Fed-style quantitative easing, or QE) and by appearing to water down the forward guidance it gave about the evolution of this program in June. "Tapering" refers to a step-by-step winding back of the $85 billion to zero. That the market was so shocked by the Fed's decision not to taper was a bit of a shock, or at least a puzzle, to us. Our call since June had been that the December Federal Open Market Committee (FOMC), not the September one, was the most likely meeting at which the Fed would start to taper. Given this week's developments, we may even have to think about pushing this timing into next year. Overview That the Fed did not announce tapering in September did not surprise us, as we have stuck to our December call. Starting to taper was conditional on U.S. growth moving up a notch, which has not happened; in fact, the Fed has lowered its growth outlook. In the wake of a financial crisis and deep recession, central banks face asymmetric risks: Tightening policy too early carries higher risks than leaving policy loose for too long. Forward guidance attempts to guide markets, but, by incentivizing markets to hang on every central bank utterance, and react in a globally synchronized way, it risks amplifying the policy signals and creating volatility. The new Fed chair should resist the temptation to overengineer forward guidance, but rather double down on the core message: The Fed has the requisite tools and is determined to use them.

Overbaked September
There were several reasons, which are worth laying out, behind our judgment that the Fed would likely decide that September was too early to start tapering. First, we sensed that the market punditry class had misread the Fed's June communication. At the June FOMC meeting, the Fed put more structure on its QE-related forward guidance and did some throat clearing on the topic of the possible or likely timing of tapering. But this in no way made a September decision a done deal. To recap, at his press conference on June 19, Chairman Ben Bernanke stated that: "Going forward, the economic outcomes that the Committee sees as most likely involve continuing gains in labor markets, supported by moderate growth that picks up

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Economic Research: The Market's Shocking Shock At The Fed's Non-Taper Shock

over the next several quarters as the near-term restraint from fiscal policy and other headwinds diminishes. We also see inflation moving back toward our 2 percent objective over time. If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year. And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains, a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced this program." At his June press conference, Chairman Bernanke delivered caveats galore, including the following: "I would like to emphasize once more the point that our policy is in no way predetermined and will depend on the incoming data and the evolution of the outlook as well as on the cumulative progress toward our objectives. If conditions improve faster than expected, the pace of asset purchases could be reduced somewhat more quickly. If the outlook becomes less favorable, on the other hand, or if financial conditions are judged to be inconsistent with further progress in the labor markets, reductions in the pace of purchases could be delayed. Indeed, should it be needed, the Committee would be prepared to employ all of its tools, including an increase in the pace of purchases for a time, to promote a return to maximum employment in a context of price stability." In a subsequent speech, Fed Governor Jeremy Stein explained the Fed's thinking thus: "the further down the road we get, the more information the market demands about the conditions that would lead us to reduce and eventually end our purchases. This imperative for clarity provides the backdrop against which our current messaging should be interpreted. In particular, I view Chairman Bernanke's remarks at his press conference--in which he suggested that if the economy progresses generally as we anticipate then the asset purchase program might be expected to wrap up when unemployment falls to the 7 percent range--as an effort to put more specificity around the heretofore less well-defined notion of 'substantial progress.'" He continued: "It is important to stress that this added clarity is not a statement of unconditional optimism, nor does it represent a departure from the basic data-dependent philosophy of the asset purchase program. Rather, it involves a subtler change in how data-dependence is implemented--a greater willingness to spell out what the Committee is looking for, as opposed to a 'we'll know it when we see it' approach. As time passes and we make progress toward our objectives, the balance of the tradeoff between flexibility and specificity in articulating these objectives shifts. It would have been difficult for the Committee to put forward a 7 percent unemployment goal when the current program started and unemployment was 8.1 percent; this would have involved a lot of uncertainty about the magnitude of asset purchases required to reach this goal. However, as we get closer to our goals, the balance sheet uncertainty becomes more manageable--at the same time that the market's demand for specificity goes up." The June communication was an attempt to rectify an imbalance in the specificity of the two strands of the Fed's forward guidance, the guidance relating to QE being much vaguer than that relating to the federal funds rate. That the Fed thought the timing was right to put more flesh on the bones of the QE-related forward guidance reflected that it thought the likely date of tapering was drawing nearer, given progress being made toward the goal of improving labor

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Economic Research: The Market's Shocking Shock At The Fed's Non-Taper Shock

market conditions. But there was nothing magic or preordained about September. Second, as the Fed has pointed out ad nauseam, forward guidance is conditional on the evolution of the economy and, in particular, conditional on the economy evolving in line with the Fed's forecasts and outlook. The Fed's QE and (near zero) interest rate policies are results-dependent, and the forward guidance underscores that point. We doubted that the economic data would show a sufficient pickup in momentum by the September meeting (or the October meeting for that matter) to cause the Fed to push the tapering button. Despite the "talking up" of the economic outlook engendered by the tapering discussion, economic conditions have been surprisingly weak in recent quarters. Real GDP growth in the past three quarters in the U.S. has averaged a paltry 1.2% quarter-on-quarter in seasonally adjusted annualized terms. The weaker growth largely reflects a significant drag from government spending, which has subtracted an average of 0.74 percentage points from growth in the past three quarters. But even assuming a neutral impact of government spending on GDP growth and adding this drag back in, growth would have been running at about 2% quarter-on-quarter, a little less than the post-mid-2009 recovery pace and hardly the notch-up in growth the Fed has been hankering after. A third reason for being skeptical that the Fed would start to taper at the September meeting was the considerable immediate uncertainty about fiscal policy that lay ahead. This week's meeting was just ahead of political negotiations in Washington over the continuing resolution to fund the government and avert a government shutdown and over lifting the debt ceiling being due to come to a head. The conventional view in academic and central banking circles is that tapering is not monetary tightening but rather a moderation in the pace of QE (expansion of the balance sheet). But the trading fraternity tends to view QE in flow terms, so any diminution in the rate of purchases could be construed by the market as a form of tightening. At the very least, given that tapering is one milestone needing to be passed on the way to eventual monetary tightening, the decision to taper would be expected to lead to a tightening of financial conditions or validate and reinforce the considerable tightening that had already taken place in anticipation of the decision. It struck us as counterintuitive that the Fed would risk triggering a further tightening of monetary conditions, or even validate the tightening that it had somewhat inadvertently triggered, when the risks of further fiscal tightening were high or the immediate visibility about the immediate path of fiscal policy was so low.

The Asymmetric Nature Of Monetary Policy Risks

A fourth overriding factor that informs our thinking about the Bernanke-Yellen Fed is the asymmetric nature of the risks of policy error. Put bluntly, it would be much more problematic for the Fed to err by tightening policy too soon than err by leaving policy too loose for too long. This follows directly from the context: the aftermath of the worst financial crisis and recession since the Great Depression. The proximate risk in these highly unusual economic circumstances--circumstances evidenced by the Fed being forced to the zero interest rate bound and deep into QE territory--has been that the economy would enter a Great Depression or deflation, or, that risk having been largely averted, languish in a prolonged slump, causing both substantial welfare losses today and permanently scarring the potential capacity of the economy. Given the starting point, the Fed has lots of room to tighten monetary policy, but, in practical (as opposed to theoretical) terms, it has limited room to ease monetary policy. So a policy error on the too tight side that results in the Fed needing to reverse course and loosen policy is potentially more dangerous than a

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Economic Research: The Market's Shocking Shock At The Fed's Non-Taper Shock

policy error on the too loose side that results in the Fed needing to play a bit of catch-up in tightening policy. Let's say the Fed leaves monetary policy too loose for too long and gets behind the tightening curve. That will lead to some overheating and eventual inflation pressure. But once the Fed realizes its error, it can calibrate by speeding up the pace of monetary tightening. It has the tools to do so: It can raise policy rates, it can calibrate the rate at which it unwinds QE (shrinks its balance sheet), and it can provide forward guidance about both. Central banks know how to tighten monetary policy, and, being independent, they are prepared to do so when they judge it to be necessary. The consequences of such a mini policy error are also fairly benign. Economic growth starting to bump up against the supply constraints of the economy and even a period of slightly above-target inflation are not the worst things in the world for an economy to confront after a prolonged period of depressed economic activity, slow growth, and below-trend inflation. What would be problematic would be a loss of the Fed's inflation-targeting credibility and the inflation expectations of the public getting un-anchored and rising as a result. But this is unlikely if the inflationary pressure results from an error of judgment rather than a change in the central bank's "reaction function;" that the Fed has demonstrated such a willingness to defend its inflation target from the threat from below (the threat of disinflation and deflation) should also buttress, not put at risk, its inflation-targeting credibility. But what if the Fed makes a policy error by starting to unwind monetary easing too early? This could be quite dangerous and damaging to the economy, particularly if the economy were to be hit by a new adverse shock or two. Apart from taking the gloss off the Fed's postcrisis policy management record, the fact that an attempt at tightening would have to be abandoned in favor of a renewed foray into QE territory could undermine the effectiveness of monetary policy at the zero bound by underscoring in the market's "mind" that the several years of unconventional policy did not work. If so, why should it work second time round, so to speak? Deep into QE expansion territory is not the starting point from which a central bank wants to launch a new round of monetary easing; policy management that minimizes the risk that the central bank gets itself into this kind of sticky situation has something to recommend it. None of this is to suggest the Fed can throw caution to the winds and engage in QE willy-nilly. But it does suggest that the Fed and other central banks similarly placed need to tread carefully when it comes to starting to unwind their crisis- and recession-triggered extraordinary monetary easing or even lay the groundwork for doing so.

Tapering Backtracking Or Reality Check?

That the Fed did not start tapering in September made sense to us. What was a bit surprising to us and to the markets was the apparent backtracking of the Fed on the conditional tapering time line that Chairman Bernanke outlined in June. Rather than a confident, albeit conditional, statement that tapering was set to begin "later this year," Mr. Bernanke noted blandly that: "We could begin later this year." And Mr. Bernanke softened the guidance that asset purchases were on course to end "around midyear [2014]," when "the unemployment rate would likely be in the vicinity of 7 percent": "Last time, I gave a 7 percent as an indicative number to give you some sense of, you know, where that might be. But as my first answer suggested, the unemployment rate is not necessarily a great measure in all circumstances of the--of the state of the labor market overall. For example, just last month, the decline in unemployment rate came about more than entirely because declining participation, not because of increased jobs. So, what we will be looking at is the overall labor market situation, including the unemployment rate, but including other

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Economic Research: The Market's Shocking Shock At The Fed's Non-Taper Shock

factors as well. But in particular, there is not any magic number that we are shooting for. We're looking for overall improvement in the labor market." It would appear that the Fed has become less confident in its baseline view, which conditions the tapering decision, that "moderate growth" would "[pick] up over the next several quarters," and indeed the Fed did downgrade its growth outlook over the near and medium term. The "central tendency" forecast (excluding the three highest and three lowest forecasts of FOMC members) for 2013 real GDP growth was lowered from 2.3%-2.6% in June to 2.0%-2.3% and for 2014 from 3.0%-3.5% to 2.9%-3.1%. One likely culprit, as noted in new text in the FOMC statement: "The tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market." But isn't this tightening and associated likely slowdown in growth largely self-induced? Ten-year Treasury yields had risen by 66 basis points between the June 18-19 and this week's FOMC meetings.

Forward Guidance As A Double-Edged Sword

Therein lies a conundrum for central banks and a reason not to put too much store in the stimulatory power of forward guidance. "Forward guidance," the latest "fad" in postcrisis monetary policymaking, refers to communication by the central bank relating to its expectation of its own future policy decisions. Forward guidance is a natural development within the framework of inflation targeting, with its emphasis on transparency and communication about the central bank's objectives, "reaction function," and assessment of economic conditions and the outlook, all in the service of helping the central bank to attain its goals by managing the public's and the market's inflation (and other) expectations. Monetary policy works on the real economy and on inflation through financial markets (and via a direct "expectations" channel), notably by easing or tightening financial conditions. So it makes sense for central banks, struggling at the zero bound, to try to ease financial conditions further (on top of QE) by using forward guidance. This presents two problems, however, one in the realm of nit-picking, the other more substantive. The nit-picking observation is that, inasmuch as forward guidance falls short of "pre-commitment,"--that is, the central bank committing in advance to behave in a possibly time-inconsistent manner in the future--it is arguable, despite the fancy name, whether it adds much to the normal transparency and communication of inflation targeting. Thus, forward guidance may be a useful refinement of inflation targeting but runs the risk of generating an amount of fuss disproportionate to its significance. The more substantive issue is that forward guidance, and heightened central bank transparency and communication more generally, may, in certain circumstances, risk being counterproductive. Central banks seek to guide markets. But because they do, markets hang on every utterance that emanates from the central bank, particularly from its head, as providing a possible clue to the central bank's future actions. Central bank communications, which come in an almost constant stream of bits and bytes, become focal points to which market participants react. And countless traders and investors the world over react at the same time. When it comes to important communications, such as policy statements, there is considerable scope for "small" or "nuanced" messages to become amplified, particularly if the unexpected component in the message is significant. In other words, in a version of "Goodhart's law" (the idea that

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Economic Research: The Market's Shocking Shock At The Fed's Non-Taper Shock

"when a measure becomes a target, it ceases to be a good measure"), central bank communication aimed at improving the transmission of monetary policy by gently guiding market expectations and damping fluctuations may, at times, induce serious volatility precisely because markets pay so much attention to it and do so in such a globally synchronized fashion. The market reaction to the June FOMC forward guidance and this week's may be a good case in point: markets being whipsawed rather than gently led.

The Limits Of Markets Serving Double Duty For Monetary Policy

Lurking behind the above conundrum, or maybe the same conundrum in a different guise, is a fundamental paradox of monetary policy: The financial conditions (particularly as expressed along the yield curve) that the central bank seeks to influence in order to transmit monetary policy and achieve its goals have to serve "double duty," both transmitting the intended monetary policy effect and reflecting the success of that policy. The yield curve has a hard time doing both at the same time; at best, it can do so only in a sequentially consistent way. Thus, QE and forward guidance are supposed to put downward pressure on long-term interest rates, beyond what the market's expectation of the future course of short-term (policy) rates would deliver, thus imparting more stimulus to economic activity. But to the extent that the stimulus works, and there is no time-inconsistent pre-commitment, long-term rates should rise to reflect the success of the policy. If the longer end of the yield curve "cooperates" with the Fed, flattening to impart stimulus and then steepening as the effect of that stimulus comes through, all well and good. But (long-term interest rate) markets being discounting mechanisms, there is no guarantee that this will be the case. The market reaction to mooted success can front-run the stimulatory effect; of course, that does not make for an equilibrium outcome, but it does set markets up for volatility and potentially signal-jam monetary policy effectiveness. That the Fed is struggling with this issue was evident in some of Chairman Bernanke's answers at this week's press conference. He said that: "Well, I think part of the reaction we've seen, and it comes from number of sources, part of it comes from improved economic news and this is part of the reason why rates have gone up in other countries as well as in the United States and that to the extent that tighter financial conditions reflect a better outlook, that's a good thing and it's not a problem at all. Part of it reflects the views about monetary policy and that we want to make sure we get straight and that's why to answer the earlier question, again, it's why communication is so important. I think the other factor which was at play was an unwinding of excessively risky and leverage positions in the markets and insufficiencies of liquidity in some cases meant that those unwindings led to larger reactions in prices and rates than might otherwise have occurred. Now, the tightening associated with that is to some extent unwelcome, but on the other hand, to the extent that some of the riskier, more lever positions have been eliminated, I think that makes the situation more sustainable and reduces at least the risk that there will be as over-strong reaction to further announcements." Then later: "Well, it's our intention to try to set policy as appropriate for the economy, as I said earlier. We are somewhat concerned. I won't overstate it, but we do want to see the effects of higher interest rates on the economy, particularly in mortgage rates on housing. So to the extent that our policy makes conditions--our policy decision today makes conditions just a little bit easier, that's desirable. We want to make sure that the economy has adequate support and in particular, is less surprising the market or easing policy as it is avoiding a tightening until we can be comfortable

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that the economy is in fact growing, you know, the way we want it to be growing." Clear as mud? Hmmm.

All Eyes On The Next Chair

It would be wrong and insulting to call Mr. Bernanke a "lame duck" chairman, but whether it was his unusual absence from this year's Jackson Hole conference in August or his less than stellar communication performance at this week's FOMC press conference, there is a palpable sense of his winding down. Vice Chairman Janet Yellen, ticking so many of the boxes, is now the short odds favorite to succeed Mr. Bernanke as Fed Chairman. Anyone else getting the nomination at this stage would be a surprise and would beg some interesting questions. Professor Yellen, with backing from Chairman Bernanke, has put two important stamps on postcrisis Fed monetary policymaking: One is refining the Fed's communications strategy and championing forward guidance. The other is giving more prominence to the full employment part of the Fed's mandate, as a way to motivate a more aggressive policy response aimed at speeding up the pace of the recovery and improvement in labor market conditions, consistent with the pursuit of price stability. This contrasts with repeating the less than helpful mantra that pursuing price stability is the best way to assure full employment even though this may result in a subpar recovery and high unemployment being tolerated in the meantime. Because the potency of monetary policy at the zero bound in the wake of a financial crisis is so muted, innovations such as QE and forward guidance are called for--and they warrant being aggressively pursued, given the hand the Fed is dealt by the other arms of policy. But forward guidance, in particular, can be overengineered. Perhaps the changeover to a new Fed chairperson is a good opportunity for the Fed to go back to basics and simplify its communication. That strategy might usefully revolve around the Fed relentlessly sending the message that it has the tools--interest rates and QE (that is, the central bank expanding the size and changing the asset composition of its balance sheet)--to both tighten and ease financial conditions in pursuit of its goals and is determined to use them to that end. The temptation to further refine forward guidance, at the risk of complicating and overegging it and inadvertently creating mousetraps for market volatility, might usefully be avoided.

Related Research
Carney Guides The Bank Of England Forward, Aug. 20, 2013 Repeat After Me: Banks Cannot And Do Not "Lend Out" Reserves, Aug. 13, 2013 "Hawk" And "Dove" Labels Are For The Birds, July 29, 2013 The Fed: Parsing Its Communications, Jan. 7, 2013 The Fed: Full Steam Ahead, Dec. 13, 2012

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