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The Antidote to the Fed's Poison -- WSJ

17 Nov 2017 7:32 am
By James Mackintosh 

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the U.S. print edition of The Wall Street Journal (November 17, 2017).

Janet Yellen has two meetings left as chairwoman of the Federal Reserve, and traders think they know exactly what she will do with interest rates. Fed-funds futures peg the chance of a quarter-point hike next month at 97%, with just a 5% chance of a further rise at her swan song in January.

Ms. Yellen has plenty of time to shake the complacency of markets, and she should. The best way is to become less predictable. An emergency Fed meeting on a Sunday could raise rates some random amount, say 0.07 percentage points. Even better, the Fed doesn't need to even issue a press release about it, let alone hold a press conference. Let the markets find out that the overnight borrowing rate has gone up when it, well, goes up.

Such talk is heresy for the modern central banker, and markets would hate it. But that is the point. Central banks have been coddling investors for years with transparency and forward guidance, to such an extent that the question of what policy makers will do has primacy over analysis of inflation and the economy.

Central bank openness and the unwillingness of policy makers to surprise investors was a powerful drug in the crisis, but leaks a slow poison into the markets. The result is that investors have piled on bad risks they would otherwise be unwilling to take on. It also degraded the quality of the signals markets send about the economy. Perhaps worst of all for central bankers, the transparency has conspicuously failed in its main job of getting investors to understand the policy process. Their magical aura is wavering, and the danger is the curtain is pulled back to reveal that mere economists control the monetary policy levers.

Each of these points is important. But there is also a question of timing. Central banks became more open about their plans for a sound monetary policy reason: they ran out of room to cut rates.

Back in 2004, the Fed worried that when it started raising rates from 1% a market panic could create economic troubles, and it didn't have much scope to respond by cutting rates further. Guiding the market about future policy succeeded in avoiding an upset like that of 1994, when unexpected rate increases rattled investors. In the wake of the Lehman Brothers collapse in 2008 the Fed cut rates to 0%-0.25%, and had to switch to bond-buying instead of further rate-cutting. Public guidance about future rates became more explicit, giving central banks -- led by the Bank of Canada, then headed by Mark Carney, now governor of the Bank of England -- an extra tool to influence longer-dated borrowing costs.

The need for that extra tool is fading. The Fed last month took its first baby steps to cut the size of its bondholdings, while the European Central Bank is buying less. They should be thinking about how to back away from their crisis-era communication strategy too, but instead they're considering making it permanent.

"Why to [sic] discard a monetary policy instrument that has proved to be effective?" asked ECB President Mario Draghi at a conference in Frankfurt this week.

"Draghi's a magician, he's tremendously good at manipulating the markets, " says Matthew Eagan, co-manager of the $13 billion Loomis Sayles Bond Fund in Boston. Yet, in the U.S. it's time to let the markets find their own levels, and as the European economy recovers, the same will hopefully soon be true for the ECB.

Forward guidance menaces markets mainly because it encourages risk taking, over and above that already encouraged by low rates. With hindsight, we can see how the predictability of Fed rate rises -- a quarter-point at every meeting from 2004 to 2006 -- freed financiers to pile on short-term leverage, with disastrous consequences. It isn't only the level of interest rates that matters.

Something similar has happened today. Low volatility has become a way of life, in part because central banks are so predictable, and it is encouraging more risk-taking. The danger is that any shock will be worse as a result -- and really big market disruptions help create recessions, as in 2001 and 2008.

Forward guidance also makes markets less useful as a gauge of what investors are thinking, and so less effective at allocating capital to the best effect in the economy.

"The more you try to influence market prices for your own ends the less informative market prices become," says Hyun Song Shin, head of research at the Bank for International Settlements in Switzerland.

In some ways this isn't the fault of the central banks, who have mostly explained that the guidance depends on what happens to inflation and the economy (after some embarrassing early mistakes, particularly from Mr. Carney). But investors want conviction, even when central banks spell out the uncertainty. The BOE is furthest ahead in explaining the uncertainty, but its prediction that there is a 90% chance that in three years inflation will be between roughly 4.5% and minus 0.5% is mostly ignored in favor of its central prediction of inflation just above 2%.

My suggestion of a small secret rate increase harks back to the pre-1994 era, when the Fed didn't announce its decisions until a month or later. Democratic accountability makes it hard for the Fed to adopt the "never explain, never excuse" maxim of former BOE Governor Montagu Norman. But for the health of the economy and their own credibility central bankers should try to break the markets' addiction to their words.

Write to James Mackintosh at James.Mackintosh@wsj.com

(END) Dow Jones Newswires

November 17, 2017 02:32 ET (07:32 GMT)

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