The Federal Reserve has a public-relations problem.
In an attempt to rein in too-hot inflation, the Fed has tried to signal to investors and the financial markets its plans for tackling rapid price growth. In order for monetary policy and interest-rate hikes to work, the markets have to clearly grasp the Fed’s goals and fall in line with those objectives. But recent communications from Chair Jerome Powell and other Fed officials have been confused at best — and you only need to look at the market’s considerable shifts over the summer to see that missteps have been made.
This is a problem not only for Powell and the Fed but for the economy. If investors stop listening to the Federal Reserve, even perfect decision-making by the Federal Open Market Committee — the Fed’s main interest-rate-setting committee — can create a tragic misstep that is either too hawkish or too dovish. To actually deliver the desired amount of tightening and bring down inflation without losing control of the process, the Federal Reserve needs to clean up how it communicates with markets.
Playing the expectations game
Markets are by nature forward-looking, anticipating the future of a company or the next few years of economic growth. To move the economy toward the outcome it wants, the Fed plays on this future-focused nature by steering financial conditions. As economic conditions change, markets take into account what the Fed and other central banks will do next. By signaling future interest-rate cuts, the Fed hopes to send a signal that leads businesses to hire and invest while households spend more — boosting the economy. In signaling that interest-rate hikes are coming, the Fed is hoping to slow asset-price growth and sap confidence, lowering spending by consumers and businesses.
Using financial conditions to modulate the economy has proved supremely useful for the Fed in the past. After the global financial crisis, interest rates were already at zero, so there were limits to how much more the Fed could boost the economy. One solution was to telegraph the intention to keep interest rates low until the economy got on steadier footing, a strategy called forward guidance. Forward guidance meant markets could price in low rates long into the future, helping keep the stock market strong and mortgage rates low even though the Fed couldn’t lower interest rates any further.
Other times, this signaling hasn’t gone as well. When the Fed began hiking rates in 2004, private-sector debt costs actually got looser. From June 2004 to September 2005, both corporate bond yields and mortgage rates fell about half a percentage point while the Fed’s main interest rate increased to 3.75% from 1%. The markets failed to get the picture, and as a result, the Fed’s efforts to slow the economy and make the 2000s expansion more sustainable were a failure. That failure arguably made the global-financial-crisis recession much worse than it otherwise would have been.
What we’ve got here is failure to communicate
Nowadays the Fed and other central banks around the globe are trying to tell markets that they intend to tighten policy to get inflation under control. The result, in theory, is a cooling economy and lower prices. But instead of guiding the markets with clarity or useful ambiguity, the Fed has given them a heaping helping of confusion and contradiction this summer. Powell and other members of the FOMC have made statements that are mutually exclusive or wildly different from previous communications. That has allowed a dangerous wedge to form between what the Fed wants and what markets are expecting. Even grading on a curve, this summer has seen some remarkable communications errors that suggest a need for reflection about the communications approach.
Take, for instance, the June FOMC meeting: Despite the Fed signaling for weeks that they planned to raise rates by 0.50%, The Wall Street Journal reported days before the meeting that the FOMC was planning to raise rates by 0.75% instead — the biggest hike in rates at one meeting since 1994. In explaining the sudden shift, Powell pointed to a single survey that suggested Americans’ expectations for future inflation were too high for comfort. But this survey had a sample of just a few hundred people and was later revised down, proving to be a false alarm.
Powell has flip-flopped on which measure of inflation the Fed is most closely watching: headline inflation, which includes goods that have volatile price changes like energy and food, or core inflation, which strips those categories out in an attempt to measure underlying price pressures. At the June meeting, Powell responded to a question about which type of inflation the Fed was targeting with a definitive “inflation means headline inflation.” But a month later, as gas prices and food prices started to come back down, Powell pivoted and said that “core is actually a better indicator of headline and of all inflation going forward” — the opposite of the stance he’d taken at the previous meeting.
Grizzled market watchers will probably roll their eyes at anyone who’s disappointed when Fed officials talk out of either side of their mouths. But those same grizzled market watchers were likely confused by Powell’s prepared remarks from the July FOMC meeting, when he said that “it likely will become appropriate to slow the pace of increases” in interest rates. It’s a logical statement of fact that the fastest pace of tightening in decades will not continue indefinitely. But by explicitly saying that, Powell gave markets an opening to assume much more.
These flip-flops have caused chaos for markets. Stock prices plunged after the mid-June meeting but soared after the subsequent meeting seemed to signal that the most intense rate hikes were over. The yield difference between risky and low-risk bonds also collapsed. That sounds like good news, but it actually represents a breakdown in the way monetary policy is transmitted to the rest of the economy.
To correct the market’s assumption that the worst of the rate hikes was in the past, Powell and other FOMC members spent weeks trying to convince investors that they were still committed to hiking rates to get inflation under control. At the annual economic-policy symposium in Jackson Hole, Wyoming, in August, the chairman tried to reverse the jubilant market action of late July and early August by sternly reminding his audience that lowering inflation would require the Fed to “bring some pain” to the economy.
This isn’t to say all markets haven’t picked up on the Fed’s path. Two-year note yields, which roughly proxy the market’s pricing of the fed funds policy rate 12 months ahead, have risen steadily. While there have been fits and starts, the move from a rate of less than 0.75% at the end of last year to almost 4% today has been remarkably smooth and steady. But the orderly move in Treasury bonds compared with the back-and-forth chaos in stocks and corporate bonds only underlines the Fed’s inability to lay out its plans.
The good news is that the bond market is confident the FOMC will succeed in bringing down inflation, and surveys of consumers and businesses suggest inflation expectations have dropped with gas prices over the past few months. The Fed is credible in the long run, but the FOMC is making its own life much harder by changing its script.
Clarity above all
There is one clear lesson for the FOMC from this summer: Communications are not working correctly. Explicit forecasts or specific focus points are being
punished by volatility and imbalanced positioning. Less communication in general would serve the Fed well.
Since I began tracking all publicly available comments from FOMC members in June 2017, a Fed speaker has talked in public more than once a day on average — and that excludes Fed minutes and policy decisions or similar press releases. Powell has also started giving eight interest-rate press conferences per year, twice as many as there were in 2018. If FOMC members said much less, it would offer much less room for confusion.
The Fed was served well by repeatedly and publicly discussing its policy approach when it was not under pressure to tighten rapidly. As the economy has shifted, so too has the Fed’s communications imperative. Less is now more — and will be plenty to meet the goal of informing markets and the public without causing confusion.