About the author: Christopher Smart is chief global strategist and head of the Barings Investment Institute, and is a former senior economic policy official at the U.S. Treasury and the White House.
The U.S. Federal Reserve could not be clearer. Hawks and doves alike present a steely determination to drive inflation down despite recession risks. They anticipate no rate cuts at least until next year. The markets, however, expect easier policy by late summer.
Has the Fed lost credibility? Or is uncertainty so high that not even the world’s largest central bank knows what lies ahead? The problem seems less with a dubious messenger than with the message, which is still lost amid clouds of uncertainty. But beware the day these clouds suddenly lift. The reckoning 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 holds that the U.S. economy suffers from underlying weakness that will tip 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 spike in unemployment to trigger insistent pleas for rate relief, especially from members of a fractious U.S. Congress looking to make headlines.
Another possibility is an expectation that financial markets will suddenly crack. Before the 1980s, most recessions were caused by Fed hikes to combat inflationary pressures in the economy. Ever since Black Monday, on Oct. 19, 1987, when the Dow Jones Industrial Average posted a 22.6% single-day decline, financial market chaos has more often led to economic contraction. The recent ructions from U.K. pension managers and exotic crypto traders have been manageable so far, but worries remain about excess leverage in private equity and rising risks from family offices and hedge funds.
Alternatively, investors may simply be stuck in the lazy supposition that they can always bank on a “Fed put” that will force rate cuts on the premise that Wall Street losses always spill into Main Street.
It could be some combination of all these reasons.
In a world awash with market news and commentary, it’s worth remembering a distant time before 1994, when there wasn’t Fed messaging at all. Rate decisions weren’t even formally announced until minutes were released following a subsequent meeting of the Federal Open Market Committee. Journalists were forced to scurry around to speak with traders to deduce whether there had actually been a policy change.
Greater transparency about the Fed’s analysis and expectations is meant to reinforce policy. When there is general consensus on likely economic outcomes, the Fed can rely on what former Chicago Fed President Charles Evans and colleagues once called “Delphic” guidance, named for the oracles in the Temple of Apollo.
In normal times, these forecasts can influence markets and credit conditions in ways that reinforce actual rate adjustments. New data may lead to adjustments in expectations, as we have seen in updates to the Fed’s Summary of Economic Projections or its infamous dot plot of future rate levels. But these remain the expectations of individual members rather than promises.
By contrast, in times of market stress, central bankers may switch to “Odyssean” guidance, lashing themselves to the mast like the Greek hero by making binding commitments to policy. In the depths of the pandemic, in September 2020, the Fed managed to magnify the impact of essentially zero interest rates with a promise of loose policy until the economy reached “maximum employment” and “inflation on track to moderately exceed 2% for some time.”
Such guidance works best when it’s “specific and verifiable,” writes Ben Bernanke, former Fed chair and champion of greater policy transparency, in his most recent book. But it also worked for European Central Bank 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 fails because there’s such wide dispersion of market expectations around inflation and growth. For decades, the Fed’s central problem has been to convince markets it could actually raise inflation to at least 2%. Now, inflation seems to have peaked but there is little consensus on how far or how fast the Fed can lower inflation back toward that 2%. There’s even less consensus on how much damage it might do along the way.
At the same time, conditions are not extreme enough to warrant a commitment to hold rates at X until inflation reaches Y. And we’re a far cry from anyone promising “whatever it takes.” Without a sense of crisis, such dramatic commitments sound even less credible.
Ultimately, the Fed’s gap with market expectations will be resolved as new data readings come in the months ahead, which may be why Powell began to offer less-specific forward guidance last summer.
The current market consensus still feels right that inflation continues to cool, but the economy remains resilient enough to avoid a serious recession. In this case, the Fed may start cutting in baby steps before year end, even if not as fast as markets currently expect.
The risk is that the difference between the Fed and investors is resolved suddenly and unexpectedly in favor of one or the other. If investors are right that the Fed will be cutting in summer, it will be because the recession arrived much sooner or markets are in turmoil. If the Fed is right that it will take longer to squeeze inflation out of the economy, the recession may be deeper.
Meanwhile, America’s central bankers are stuck with guidance that is not especially effective. Indeed, no Greek hero or oracle ever uttered the words “data dependent.”
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