(James Saft is a Reuters columnist. The opinions expressed are his own)
By James Saft
July 10 (Reuters) - The Federal Reserve, after a long campaign to become more transparent, now appears to be unhappy that it is so well understood.
Along with letting us know that QE is likely to come to an end in October, Wednesday’s minutes from the June meeting of the Federal Open Market Committee were notable for a rather badly aimed shot the U.S. central bank appears to have tried to put across the bow of exuberant financial markets.
Specifically, the Fed seems to be wondering how to put the mystery back in its relationship with investors.
“Participants also discussed whether some recent trends in financial markets might suggest that investors were not appropriately taking account of risks in their investment decisions,” according to the minutes.
“In particular, low implied volatility in equity, currency, and fixed-income markets as well as signs of increased risk-taking were viewed by some participants as an indication that market participants were not factoring in sufficient uncertainty about the path of the economy and monetary policy.”
In plain English, the Fed wishes investors were a bit more jittery and a bit less fat and happy. To be sure, they have a point about overconfidence: this is the week in which a little-known social media company with one employee (whose other job, apparently, is to promote medical tourism to Tijuana) and no revenue achieved a market cap of over $5 billion. (here)
But why exactly, given the Fed’s own stance, it would expect investors to be more cautious is a lot less clear.
Fed watcher Tim Duy, economist of the University of Oregon, points out that the Fed, after all, is now showing a lot less uncertainty in its own economic forecasts, with far fewer describing themselves as having higher than usual uncertainty about key data than one or two years ago.
That leaves their own policy as the main other potential source of uncertainty.
"If the Fed has a well-communicated reaction function, and there is little uncertainty about the outlook, why should there be uncertainty about the path of monetary policy? The Fed's unease about complacency seems misplaced. The goal of the communications strategy should be to limit uncertainty regarding the path of monetary policy by clearly defining the objective function. The only residual uncertainty will be economic uncertainty.," Duy writes. (here)
An interesting insight into the Fed’s mindset may have been given by Jeremy Stein, the now departed Fed governor who gave his first post-office interview to the Washington Post on Wednesday.
“I have continued to be puzzled by how low various measures of volatility are, which concerns me a little bit,” Stein said, in response to a question about the challenges the Fed faces in communication.
"Based on the fundamentals, if you think about all the uncertainty about what's the right long-run rate, when is the Fed going to lift off, it just doesn't feel like this is a very low-volatility environment." (here)
Stein is exactly right: investors should be far more uncertain and in consequence prices ought to be a good bit lower for most risk assets in order to reflect the potential costs of those uncertainties.
To call this puzzling, however, I think is a bit inaccurate, and Stein is reasonably well placed to understand why this should be. Stein, who chose to return to Harvard, was the Fed’s leading advocate, in an understated Fed way, of using monetary policy as a tool to sometimes control overheating markets.
That view has been resoundingly rejected by Fed Chair Janet Yellen, who instead believes that macroprudential measures, essentially regulation and suasion, are more effective for controlling market excesses.
While acknowledging “pockets of increased risk taking across financial markets”, Yellen continues to see justification for a sort of church and state separation between monetary policy, which should look after employment and inflation, and macroprudential policy, which aims to keep markets and institutions safe.
The problem, to put it bluntly, is that investors can read.
They understand that the Fed isn’t going to be pouring cold monetary policy water on the market, and that, at least so far, the preconditions for a rate hike have not been reached. Wage growth is weak, and though inflation is trending in the right direction, it still is not at the Fed’s 2 percent target.
That may not be wise, but that’s what markets, and the investors who make them up, are like.
The Fed, in other words, has communicated all too well. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at firstname.lastname@example.org and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)