The Fed has been known for years for intelligently managing market expectations. Investors almost never “miss” their estimates regarding the Fed’s moves and the expectations are reflected in the various moves such as the interest rates on the bonds long before any decision, and in a fairly accurate way. However, it seems that recently this ability has also been cracked. The evidence for this is the high volatility in the market around the publication dates of Fed decisions or meeting minutes, as well as the frequent changes in market assessments regarding these decisions, as well as the lack of consensus in market expectations, unlike in the past. Why does the Fed fail to make its intentions clear to the market?
This Thursday, the annual Governors’ Conference will begin in Jackson Hole in the state of Wyoming in the United States. All eyes will be on Federal Reserve Chairman Jerome Powell and his speech on Friday, as investors look to hear more clues from his words. The market is thirsty for clearer indications about the next steps the US central bank will take regarding interest rates and reducing the balance sheet (monetary tightening ), as well as regarding the Fed’s own expectations regarding growth and inflation, which will give direction regarding its next steps. What does Powell think about the rapidly cooling housing market (even though there is still no drop in prices), about economic indicators that are weakening (the Purchasing Managers’ Index), about the strong employment market but which shows First signs of a slowdown? Will we hear only general statements again?
Can’t be clear to the market, or don’t want to?
Investors are desperate for more clarity, which Powell refuses (or can’t?) provide. His formulations in recent months are non-binding and provide more ambiguity than decisiveness and clear instructions. He does say that the most important goal is to lower inflation, but gives no indication that to fight it he will be ready to raise the interest rate by 1% on the 21st of next month. Nor does he suggest that there might be a ‘slower’ rate hike of 0.25%. In other words, the market can’t figure out what the Fed’s next move will be.
It may be a conscious decision by Powell who wants a certain lack of clarity, in order for the threat of monetary tightening to hover over the markets, without “pulling the trigger” and exercising it in all its power in practice, and on the other hand, without having to “break the word” with idle threats.
Why would the Fed resort to ambiguity?
We will explain it a little more. The Fed wants to cool inflation. For this purpose, it is enough that the financial and real markets (what is sometimes called in traders’ parlance: “Wall Street” and “Main Street”) fear an interest rate increase and a slowdown, which will cause them to moderate economic activity and lead to an increase in prices. But what will happen if the market fears something that will not happen in the end? In a situation where the Fed does not fulfill its promises and threats, for example, it will say that it will raise the interest rate at a high rate and in the end raise it at a lower rate, this “sword” that the Fed waves will become meaningless the following month – the Fed will lose the confidence of the market. On the other hand, if the Fed announces an easing policy in advance, it will not achieve its goal of moderating economic activity for the purpose of fighting inflation, and even then the Fed’s measures will become meaningless. This may be the reason that Powell chooses to express himself in a way that the market is afraid and uncertain on the one hand, and on the other hand he leaves himself enough rope to not act with full force in a way that will really harm the economic activity. That is, this lack of clarity serves his purposes.
It is possible, however, that the Fed really wants to keep all options open, as Powell and the other members of the Fed repeatedly say, that they carefully examine the data and decide on further moves based on that. In this case they do not provide clarity to the market because the situation is not clear, meaning they really do not know what their next steps will be, and not because they want the market to fear.
Another factor to consider is that the Fed is still carrying the hump of last year’s failure to estimate inflation. For a long time, the Fed defined inflation as “passing” and was late in taking the appropriate steps to curb it. It is possible that this is precisely why the central bank prefers to sit on the fence this time. The economists are still trying to understand what caused this mistake, and the discussions on the subject remain for now without a complete answer. The discussions regarding the question of how long inflation will last and how severe it will be do not yet lead to clear conclusions. In such a situation it may be better to “be modest” and not make firm statements.
The mitigating circumstances of the Fed – the world has not experienced such a reality in the past
To the credit of the Federal Reserve and Powell, as well as the other central bank governors, we note that the macro conditions in the last two years were unusual and unique, so it is difficult to accuse them of being unable to act accurately. The corona epidemic caused an unprecedented crash in demand, and immediately after it unprecedented excess demand was created. Even in a normal situation where the supply side enjoys complete flexibility, we would expect to see great difficulties in responding adequately to such extreme changes.
But the situation is not normal. The supply side does not enjoy flexibility at all, but instead encounters unprecedented difficulties. Whether it is in the ports or due to the war in Ukraine, closures in the world’s largest product supplier, China, and following all of this, very unstable and very high energy prices throughout most of the period. These are chaotic and very difficult conditions to deal with both on the supply side and on the demand side, so that the central banks are given a “discount” in relation to their inability to anticipate inflation, and in the failure recorded so far in attempts to curb it and restore the balance between demand and supply, the same balance that prevented price increases for a long time so much
In any case, it is very possible that this failure, and the work that we are still in a territory that is not known from the economic books in so many respects, causes modesty, or rather hesitancy, in the management of market expectations and in the statements of the bank executives, led by Powell.
Should the Fed still be more decisive and clear?
At the same time, some believe that the Fed must be more decisive and clear in its statements. Former New York Fed President William Dudley wrote last week that the Fed must warn bullish investors who are underestimating the Fed’s monetary tightening policy and driving up asset values. He said this in the context of the bull market in July and the first part of August, which resulted, among other things, from investors’ understanding that the Fed was going to be more “soft” in its policy.
There are those who dispute the direct link that Dudley wove between the value of assets in the stock market and inflation, but the criticism overshadows the point we are talking about – unclear statements that could cause erroneous assessments of the market, something the Fed has avoided in the past.
So is this a deliberate decision by the Fed that stems from a desire to create uncertainty, from real uncertainty that stems from the unique market conditions, or from hesitation and fear of being “blamed” by mistake? It is difficult to give unequivocal answers. We are living in an extraordinary period economically, and the Fed’s moves in this period, including the statements will provide a livelihood for economics lecturers for many generations.