Models, Guidance, Humility

Has Jay Powell Learned an Important Lesson?

Behind the headlines at this week’s Federal Reserve meeting—where the FOMC hiked the short-term interest rate again, by three-quarters of a percentage point—the Fed took a welcome, though inconclusive, step toward humility.

Having been embarrassed by its “forward guidance” to investors, the Fed chairman, Jay Powell, said in a post-meeting press conference, “We think it’s time to just go to a meeting-by-meeting basis, and not provide the kind of clear guidance that we had provided.”

Potentially, this represents a retreat from the Fed’s fetishistic impulse to insulate investors, as it were possible, from every possible market development and disruption.

In recent years, the Fed has tried to guide investors by telegraphing its future plans for interest rates. The theory was, if the Fed signaled its intentions, it would steer bond investors and thus long-term interest rates closer to where the Fed wanted.

In effect, the Fed would impose a groupthink on investors, rendering markets less volatile. “Forward guidance” began informally, in the 1990s; eventually it became policy. As an official Fed abstract stated, “The new mindset stressed the stabilizing effects on the economy” of communicating policy intentions.

What’s so bad about that? Look at the date of that Fed report: May 2021. That was shortly after the March 2021 FOMC meeting in which the Fed’s forward guidance was that interest rates would remain at zero percent for the rest of the year …. and for all of 2022 and for all of 2023. Any investor banking on the Fed’s guidance could have taken a nearly three-year sleeping pill secure in the knowledge that short-term money would still be free when he or she awoke.

Except, it wasn’t. Wednesday’s announcement was the fourth rate hike this year, bringing the overnight federal funds rate to approximately 2.5%. And it’s only 2022.

No shame on the Fed for failing to perfectly model the future. That’s what models are: imperfect.

The fault lies in the arrogance of hijacking Fed policy to public forecasts. They present a certainty to investors, but it’s a false certainty.

Financial risk does not ultimately depend on communications. It depends on the inherent uncertainty in future events. The multiplicity of factors affecting interest rates—pandemics, war, oil prices, supply chains, overseas economic developments, to name only a few—will often frustrate the best of forecasters and their computer models.

To the extent that events unfold in a way that surprises —and sooner or later they surely will--volatility is a healthy and appropriate response. That is what markets are for—repricing assets as news or facts on the ground change. Reassuring forecasts that numb investors into a soporific complacency will only make the volatility, when it arrives, worse.

There is an apt analogy in the corporate world. Most publicly traded companies try to guide investors on future earnings. (Warren Buffett’s Berkshire Hathaway is a notable exception.) Their idea is that stock prices will be smoother. And so they are—until they aren’t.

Investors in equities would be better served if CFOs were more humble. I’d like to hear one of them say, “Business is ok so far, but who knows how the rest of the year will go.” An admission of risk might result in a slight discount to stock price, as investors priced in the fact of uncertainty. But it would be an honest price.

Humility would also serve the Fed. Its forecasts have repeatedly proved no better than anyone else’s. And its attempts to cushion markets have weakened both investors and the Fed itself.

Bond markets would perform better if investors did their best to price in risk according to actual Fed policy moves rather than its assurances about the future. The Fed anyways cannot save them from volatility.

In this cycle, the Fed was blind to the risk, then blind to the fact, of inflation. When it changed course, volatility was inescapable. In June, as word of the biggest rate hike since the Bill Clinton era coursed through markets, the 10-year bond suffered its largest one-day spike in two years. As a portfolio manager told Reuters, “As data comes out, speculation starts to come in; that can increase volatility in itself.”

Forward guidance had been deemed particularly useful when interest rates were zero. Since the Fed couldn’t move the short-term below zero, signaling that rates would remain at nil was a way of increasing the stimulus during a crisis.

The problem with this theory is that guidance can never be better than the predictive powers on which the guidance is based. Consider how the guidance worked in practice. The biggest beneficiaries of guidance were said to be to banks, who were reassured that they could continue issuing low-interest business loans and mortgages. Banks that did so now are saddled with unprofitable assets.

The more serious harm was to the Fed itself. By repeatedly pronouncing that it would first wind down its program of asset purchases, and only then move toward normalizing interest rates, it created expectations that rate hikes were well in the future.

No surprise that the Fed became a prisoner of its own guidance. The long delay in raising rates allowed inflation to gather momentum. It made suppressing inflation more difficult and painful. The assurances of Treasury Secretary Janet Yellen notwithstanding, no one can say if the Fed will succeed without triggering a recession.

Has a lesson been learned? One hopeful sign is that the European Central Bank, and some others, have also taken steps toward putting forward guidance on the shelf. Powell was seemingly of two minds. While explicitly proclaiming a “meeting-by-meeting” approach, he also uttered a soothing comment about future policy, expressing hope that “As the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases…”

The guess here is that the habit of trying to condition the market will be hard to break. The Fed should give investors credit. As conditions change, markets will do what they do best—react to new information. Forecasting the turns in advance is more than the Fed can, or should, hope to deliver.