What we’ve got here is a failure to effectively communicate at the Fed

Federal Reserve Vice Chairman Richard Clarida made a high-profile speech at an annual forum in New York last week about U.S. monetary policy that seemed perfectly timed to provide more clarity on the fate of the Fed’s forward guidance, which now looks at odds with the central bank’s apparent new policy stance of “patience.”

After all, his speech was titled “The Federal Reserve’s Review of Its Monetary Policy Strategy, Tools, and Communication Strategies.” Unfortunately for anyone hoping for a clearer view of what the Fed will be doing in the coming year, Clarida didn’t pull back the curtain as much as we had expected.

{mosads}As recently as December, the Fed still thought “further gradual increases” in the federal funds rate were needed to sustain both strong labor markets and on-target inflation.

Just a few weeks later in early January, Clarida announced in a speech that he had come to believe the rate-setting Federal Open Market Committee (FOMC) “can afford to be patient” in deciding when or whether to adjust policy rates further, thereby endorsing an end — or at least a pause — in the Fed’s rate-hike cycle.

The January FOMC meeting adopted the new language, but it didn’t completely do away with the previous policy of forward guidance, which the Federal Reserve website defines as “[c]ommunication about the likely future course of monetary policy.” 

And that’s problematic. If the Fed is now truly on hold and data-dependent, which is what investors seem to assume, it would be quite inconsistent to still publish forecasts for the appropriate future levels of the federal funds rate.

In December, the “dot plot” — “a visual representation of how many members think rates will hit a given level over the short, medium and longer run” — still showed a median FOMC members’ forecast of two additional rate hikes this year and one more in 2020. 

It should be obvious that Fed “patience” and calendar-based forecasts of policy-rate increases are incompatible. If “patience” really means pause and no further rate hikes this year, as the futures markets now imply, then the dot plot has to go. 

It’s fair to assume that inconsistency is a significant part of the Fed’s review of its communication tools. Hence, the interest in Clarida’s most recent speech on the topic, just a few weeks before the March FOMC meeting at which those changes would have to be announced.

Yet, Clarida merely stated the reason for the review is that “the U.S. economy [is now] operating at or close to our maximum-employment and price-stability goals,” which makes this “an especially opportune time to conduct this review.”

His comments focused more on the scope of the review, which may include novel policy tools such as price-level targeting or inflation “make-up” strategies, but they added little on the more pressing issue of what to do with the existing communications tools that are still designed to support the forward guidance. 

In fact, what was completely missing in the framework that Clarida laid out was a recognition of the greater role of asset prices in an environment of stable core inflation trends.

If anything, the 2008 financial crisis taught us that the biggest threat to the Fed’s dual mandate isn’t the potential of a wage-price spiral if unemployment is allowed to fall too much — especially not in a world of a flat Phillips Curve, the theory that holds unemployment and inflation move in an inverse relationship.

Rather, the big concern is runaway asset prices, which encourage the buildup of leverage and whose mean-reversion can undermine financial stability.

With the future of the dot plot as yet uncertain, Fed Chair Jerome Powell will have a lot of explaining to do in March. By ending the publication of policy-rate forecasts, the Fed would essentially endorse the current market expectations of no further rate hikes this year. 

Yet, it’s not clear that is the message the Fed wants to send. In fact, the minutes of the January FOMC meeting highlight that “patience” isn’t really a new policy stance but rather a reflection of the uncertain market and macro outlook.

{mossecondads}For many FOMC members, “[I]t was not yet clear what adjustments to the target range for the federal funds rate may be appropriate later this year.” That sounds like the door was still open for further rate hikes in 2019. 

Furthermore, the minutes showed that at least some members still hadn’t given up on the prior strategy, indicating that “if the economy evolved as they expected [it would be] appropriate to raise the … federal funds rate later this year.” That doesn’t sound like an end of the rate-hike cycle or the basis for an extended pause.

The bottom line here is, if Powell announces the end of the previous forward guidance-related communication, markets will rally, believing the rate-hike cycle is over and the next move is possibly a rate cut.

But if the FOMC keeps the dot plot and still shows expectations of one or two more rate hikes, markets are likely to react more negatively. So get the popcorn ready: The March FOMC meeting could launch some potent fireworks.

Markus Schomer, CFA, is the chief economist at PineBridge Investments, a private, global asset manager.