by Larry Hatheway | April 25th, 2022
This past week, stock and bond markets took it on the chin. Fears that the Federal Reserve Open Market Committee (FOMC) may hike rates by a half percentage point at each of its upcoming meetings resulted in sharp jumps in bond yields and renewed nervousness in global equity markets. Unexpected earnings disappointments among some of Wall Street’s most reliable technology stocks added to investor woes.
Last week Fed Chairman Powell effectively endorsed a half-point hike at the Fed’s upcoming May meeting. Bond markets now discount up to four such moves over the next six months. In recent weeks, a bevy of FOMC members has endorsed a more rapid tightening of US monetary policy.
The Fed’s longstanding communication objective is to avoid nasty surprises on both Wall Street and Main Street. But can the Federal Reserve genuinely be as transparent as it would like? Can it still communicate its intentions clearly? Will its message be understood?
For reasons outlined below, the Fed’s communication job is becoming more difficult. And because most Wall Street traders and investors have never worked during an era of high inflation, they may fail to appreciate the importance of changing Fed communication. A lot is at stake, including an avoidable recession and potentially a crash on Wall Street.
In the parlance of economics, the critical issue is understanding the Fed’s ‘reaction function’. That’s shorthand for how central bankers evaluate economic and financial conditions as they set interest rates. For the Federal Reserve, which has a dual mandate of achieving maximum employment and stable prices, its reaction function is typically approximated by a ‘Taylor Rule’, named after the economist John Taylor.
Essentially, the Taylor Rule suggests that the Fed sets interest rates according to deviations in actual inflation from its desired level (i.e., 2%), and to deviations of unemployment from its desired level. The desired level of unemployment is typically referred to as the ‘natural rate’, which is the lowest rate of joblessness consistent with non-accelerating inflation. The Taylor Rule also has a term for the ‘neutral rate of interest’, which is the rate that prevails when both inflation and unemployment are at their desired rates.
Usually, the Fed’s communication strategy follows the Taylor Rule. Guidance about policy intentions is provided by a discussion of the current and expected deviations of inflation and unemployment from their optimal levels. Part of the Fed’s challenge today, however, is the presence of unusual levels of economic uncertainty. De-globalization, the on-going pandemic, enormous fiscal easing, extraordinary interventions in labor markets and, most recently, Russia’s invasion of Ukraine and the West’s ensuing sanctions have resulted in unprecedented and simultaneous shifts in global supply and demand curves. Those outcomes have created tremendous uncertainty about the sources of today’s soaring inflation, as well as its future trajectory.
But the Fed’s greatest communication challenge isn’t about economic uncertainty, even if it is unusually high today. Instead, before long the Fed will have to pivot from a hawkish view on inflation to a more nuanced one about growth, and it will have to do so before inflation has fallen to its desired level. In the terminology of the Taylor Rule, the Fed will have to guide its stakeholders (Wall Street and Main Street) along a difficult journey from today’s need to fight inflation to tomorrow’s priority of declaring victory before that is obvious.
That might sound theoretical. It is not. It is vital to proper monetary policy decision-making and, by extension, to key economic and markets outcomes. Nothing less than an avoidable recession and a stock market crash hinge on the Fed’s ability to communicate and the market’s ability to understand.
It might be tempting to say this is just about the Fed being ‘data dependent’. It is not.
To see why not, it is useful to recall that since the Fed adopted a policy of ‘data-dependent’ decision-making in the mid-1990s, actual and expected inflation have oscillated narrowly around the Fed’s target of two percent core inflation. The upshot is that ‘data dependent’ policymaking over the past quarter century has focused almost exclusively on deviations of actual unemployment from the ‘natural rate’. The Taylor Rule became univariate 25 years ago.
That’s no longer the case, courtesy of soaring inflation. Some might conclude, therefore, that the Fed should now simply shift its focus from unemployment to inflation. Indeed, that seems to be what bond markets and many Federal Reserve members are now saying.
But it is not that simple. The shift from focusing on unemployment to inflation is not merely switching variables in a static equation. It is about shifting the field of vision from the present to the past.
That’s because inflation is famously a lagging variable. It tells us where the economy has been, not necessarily where it is headed. Unemployment, on the other hand, is a contemporaneous reading of where the economy is. To the extent the Fed now sets policy based on the gap between the prevailing level of inflation and its desired rate, it will react to economic conditions months or quarters ago that have delivered today’s rate of inflation. That is in marked contrast to a reaction function based on unemployment, which bases monetary policy decisions on prevailing economic conditions.
Rear-view gazing may be compounded by emphasizing inflation expectations, which the Fed is apt to do. That’s because inflation expectations are more likely adaptive than forward-looking. Consumers, businesses, and financial market participants based their inflation outlooks on what they experience, not on models. Accordingly, monetary policy based on inflation expectations risks reinforcing its backward-looking orientation.
To wit, a Fed policy focused single-mindedly on inflation — as a Taylor Rule approach would suggest is now appropriate — will recommend tightening based on where the economy has been, not necessarily where it is headed. That is because the Taylor Rule is not symmetric in the dimension of time. The Fed surely understands that point. But that fact does not make communicating the implications to a potentially skeptical audience any easier.
The critical points are the following. First, will the Fed slow, pause, or even reverse its tightening pace if contemporaneous data indicate that economic activity is weakening, even while actual inflation remains above target? Second, will the Fed be able to communicate that balancing act to investors who have no lived experience with inflation as a policy priority?
The answers to those questions are the difference between soft and hard landings — the economy and markets. If the Fed cannot reassure consumers, businesses, and investors that it will pivot when appropriate, the risk is that tight monetary policy and tight financial conditions will unnecessarily undermine growth, profits, and asset prices.
It is worth underscoring that this is not just about making the right policy decision. It is also a communication challenge. For a central bank now burnishing its anti-inflation bona fides, the question arises: Will it be able to credibly pivot to a nuanced message that ‘second derivatives’ (decelerating growth) are more important than above-target inflation?
Most investors and traders on Wall Street today are too young to have lived and worked in an era of high inflation. They have only experienced an era of a Taylor Rule with one objective — unemployment — not two. They are about to find out what that means.