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Marriner S. Eccles Federal Reserve Building in Washington, D.C.
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About the author: Christopher Smart Chief Global Strategist and President of the Barings Institute of Investment, and a former senior official for economic policy at the US Treasury Department and the White House.
The US Federal Reserve could not be clearer. Hawks and doves alike represent a steely determination to push inflation down despite recession risks. They expect not to cut interest rates at least until next year. However, markets expect an easier policy by late summer.
Has the Fed lost its credibility? Or is the uncertainty so high that not even the world’s largest central bank knows what lies ahead? The problem seems less with the questionable messenger than with still missing amid clouds of uncertainty. But beware of the day these clouds suddenly rise. The account may not be pretty.
There are several ways to explain the current disconnect between what the Fed says and what its audience hears. One theory is that the US economy is experiencing an underlying weakness that will spiral into a deep recession as the housing market stalls, consumer confidence collapses, and millions are thrown out of work. There’s nothing like a sharp rise in the unemployment rate to spark urgent pleas for rate relief, especially from divided US Congressmen looking to make headlines.
Another possibility is the expectation that the financial markets will suddenly collapse. Prior to the 1980s, most recessions were caused by Federal Reserve increases to combat inflationary pressures in the economy. Since Black Monday, on October 19, 1987, when the Dow Jones Industrial Average posted a 22.6% drop in a single day, financial market chaos has often led to economic downturns. The recent turmoil from UK pension managers and exotic cryptocurrency traders is manageable so far, but concerns remain about excessive leverage in private equity and rising risks from family offices and hedge funds.
Alternatively, investors may simply be stuck in the lazy assumption that they can always count on a “Fed mode” that will force rate cuts on the basis that Wall Street’s losses always pass on to Main Street.
It could be a combination of all of these reasons.
In a world filled with market news and commentary, it is worth remembering a time long before 1994, when there were no messages from the Federal Reserve at all. Rate decisions were not officially announced until the minutes following the subsequent FOMC meeting. Journalists were forced to rush to talk to merchants to deduce whether there had indeed been a change in policy.
More transparency about the Fed’s analyzes and forecasts is intended to bolster policy. When there is a general consensus on likely economic outcomes, the Fed can rely on what former Chicago Fed President Charles Evans and his colleagues once called “Delphic” guidelines, named after the oracle at the Temple of Apollo.
In normal times, these expectations can affect markets and credit conditions in ways that reinforce actual price adjustments. New data may lead to revisions in expectations, as we have seen in updates to the Fed’s Summary of Economic Outlook or the infamous dot chart of future price levels. But these remain expectations of individual members, not promises.
By contrast, in times of market stress central bankers may turn to Odyssey’s guidance, attacking themselves to the mast like a Greek hero by making binding policy commitments. In the depths of the pandemic, in September 2020, the Fed managed to amplify the impact of essentially zero interest rates with the promise of loose policy until the economy reached “maximum employment” and “inflation is on track to moderately exceed 2% for some time.”
Such guidance works best when it is “specific and verifiable,” Ben Bernanke, former chairman of the Federal Reserve and champion of more transparency in policy, writes in his latest book. But it also worked for ECB President Mario Draghi when he promised to do “whatever it takes” to preserve the euro.
The Fed’s current dilemma is that its Delphic guidance failed because there was such a wide divergence of market expectations around inflation and growth. For decades, the Fed’s central problem has been convincing markets that it really is possible upload Inflation to at least 2%. Right now, inflation seems to have peaked but there is little consensus on how far or how fast the Fed can do it minimum Inflation returns to 2%. There is less consensus on how much damage you might do along the way.
At the same time, conditions are not severe enough to justify a commitment to keep rates at X until inflation reaches Y. And we are a long way from anyone who promises “whatever it takes.” Without a sense of crisis, such dramatic commitments seem less credible.
Ultimately, the gap between the Fed and market expectations will be resolved as new data readings come in in the coming months, which may be why Powell started giving less specific guidance last summer.
The current market consensus remains correct that inflation continues to moderate, but that the economy remains resilient enough to avoid a serious recession. In this case, the Fed may start making small steps before the end of the year, even if not as quickly as markets currently expect it.
The danger is that the divergence between the Fed and investors resolves abruptly and unexpectedly in favor of one or the other. If investors are right that the Fed will cut interest rates in the summer, it will be because the recession arrived early or the markets are in turmoil. If the Fed is right that it will take longer to get inflation out of the economy, the recession could be deeper.
Meanwhile, US central bankers are stuck with guidance that isn’t particularly effective. In fact, no Greek hero or oracle ever uttered the phrase “data-dependent.”
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