Fed's word is its bond, now lost in translation
WASHINGTON/NEW YORK (Reuters) - It probably seemed like a good idea to Federal Reserve officials at the time.
But their decision to stick Fed Chairman Ben Bernanke out on live television two weeks ago to explain how the Fed aims to scale back and eventually end its massive economic stimulus program, without having the message in a well-parsed policy statement he could hide behind, backfired badly.
Trying to publicly explain a nuanced plan that has some key caveats may have been bold but the risks of the message getting garbled in the middle of the Wall Street trading day was high - and that is exactly what happened. Financial markets anticipated the Fed would start hiking interest rates late next year, earlier than the Fed's own expectations, and central bank officials spent much of last week trying to undo the damage.
It capped a series of communication missteps that have exposed the limit of the Fed's ability to manage expectations about interest rates and when it will wind down its bond buying program that provides the stimulus.
"We're trying to communicate, in a plain-speaking and very transparent style, and people misinterpret that as us trying to send hints," New York Fed President William Dudley told reporters when asked how communications were fumbled.
Several Fed officials also told Reuters in the past week they are aware markets think they bungled the message, and are resigned to suffering criticism for delivering unwelcome news, but view some of the ensuing volatility as inevitable given the difficulty in communicating when the economy is at an inflection point. They declined to be identified.
To some, these are worrying comments. With interest rates near zero, communications are a central tool in holding down borrowing costs to spur economic activity. The wrong signal risks markets sending rates higher and choking off economic growth.
Yet it wasn't the first recent stumble from a Fed that has prided itself on clarity since Bernanke took the helm in 2006.
At its May meeting, officials tweaked their statement by explicitly spelling out the pace of bond buying could be ramped up as well as curbed from the current $85 billion per month. The change seemed dovish, or leaning toward continued or even increased monetary easing. But it masked a more hawkish bias to the policy debate revealed when minutes of the meeting were published three weeks later.
That day, May 22, turned out to be another bad one for communication.
Bernanke appeared before a congressional panel and his written remarks warned of the dangers of dialing back the Fed's stimulus prematurely, a clearly dovish commentary. But when his appearance shifted to a question-and-answer session with lawmakers, he dropped a bomb: The Fed could start purchase reductions in "the next few meetings."
It sparked a stampede for the exits in financial markets. By the end of May, more than $1 trillion had been wiped off the value of global stocks, a figure that would reach $2.75 trillion before markets finally settled early last week.
The yield on the 10-year Treasury note churned higher. It hit a two-year high of 2.6 percent last week, a full point above its level in early May, having dragged consumer borrowing costs like mortgage rates higher along the way. U.S. bond market losses topped $750 billion over four weeks.
To be sure, the Fed has been pouring so much cash into the economy since the financial crisis hit in 2008, mainly through its unprecedented level of purchases of government and mortgage-backed securities, that any move to slow down the printing presses may be destined to create some wild gyrations in the markets - no matter how the message is delivered.
And sure enough, the sell off finally ran out of steam last week after a concerted effort by Dudley and other Fed officials to persuade investors they had over reacted to the series of messages.
"It's a subtle message to try and get across to a market that doesn't want a subtle message. That's part of the problem. If you are a hedge fund manager, or other investors too, you want the next big trade," said Sean Callow, a currency and rates strategist at Westpac in Sydney.
The resulting confusion has also hurt the institution's reputation for being sure-footed, at a time of mounting questions over who will lead it if Bernanke, as expected, steps down as chairman in January.
Next Wednesday's release of minutes from the June meeting may shed light on the decision to send Bernanke out with such a complex message rather than formally vote on the content of the remarks and enshrine them in its policy statement, which is issued at the end of a Federal Open Market Committee meeting.
At the same time, the minutes may rattle investors further if they highlight deeper divisions on the policy-making FOMC.
Should future episodes be equally sloppy, it risks undermining a tepid economic recovery because the markets keep linking the reduction of bond buying with rate hikes. A rapid rise in interest rates and sharp declines in stock and bond prices could hurt the confidence of investors, consumers and businesses, threatening to hurt spending on everything from new homes to industrial equipment.
"I think we could have communicated better," Richmond Fed President Jeffrey Lacker told reporters in West Virginia last week. "It is too much to expect markets to not change their assessment of when interest rates are going to rise when they change their assessment of the path of asset purchases."
Bernanke had emerged from the June 19 meeting to say the central bank expects to reduce the pace of purchases later this year and to halt the program altogether midway through next year, when unemployment is around 7 percent, as long as the economy improves as expected.
He also sketched out the Fed's expectations for keeping rates low in the years ahead and for the even longer-term plan for shrinking the central bank's $3.4 trillion balance sheet.
"Well, that's three different parts of forward guidance," said Peter Fisher, senior director of the BlackRock Investment Institute. "I've been in this business a long time, and bond market guys aren't that clever. We can't price all that in.
"I don't think he miscommunicated, I think they were over-ambitious," Fisher added.
One of the dissents in June came from St. Louis Fed President James Bullard, who subsequently issued a withering criticism of his colleagues for reverting back to calendar-based guidance for bond buying, despite inflation being persistently low. If businesses are unable to raise prices it could signal that the underlying economy is worryingly weak.
Wall Street is now unclear what happens if unemployment falls faster than expected. A recent Reuters poll found at least four top economists projecting a 7 percent jobless rate by the end of 2013 - about six months before the Fed sees that happening. The rate is currently at 7.6 percent.
"Maybe they shouldn't be trying so hard to guide the markets, because they haven't shown any market savvy in that regard anyway," said Ioan Smith, a UK-based managing director of Knight Capital.
(Corrects name of bank in paragraph 16 to Westpac from Westphalia)
(Additional reporting by Pedro da Costa in Washington, Ann Saphir in San Francisco, Steven C. Johnson in New York, Vidya Ranganathan in Singapore and Alistair Smout in London; Editing by Dan Burns, Martin Howell)