- Yellen Fed begins to take shape.
- The two upcoming FOMC press conferences will give Yellen ample opportunity to define the nature of monetary policymaking under her leadership.
- We expect Yellen to give considerable attention to how forward guidance is communicated.
Over the course of the next few meetings of the Federal Open Market Committee (FOMC), the character and spirit of the Yellen Fed is likely to take shape with some noticeable differences from the Bernanke era. FOMC meetings are scheduled for 17-18 March, 29-30 April, and 17-18 June 2014. The March and June meetings include a press conference by the Chair and the release of a revised quarterly "Summary of Economic Projections," which gives the views of FOMC members. The two press conferences will give Yellen ample opportunity to define the nature of monetary policymaking under her leadership. We expect Yellen to give considerable attention to how forward guidance is communicated.
Central bankers around the world have come to believe that forward guidance about how they will conduct monetary policy can make a key difference to policy effectiveness. Part of this belief is grounded in the nature of markets as discounting mechanisms for expectations. Discussions and explanations about the direction of future policy can result in immediate market reactions, as evidenced in May-June 2013, when former Fed Chair Bernanke commenced QE "Taper Talk" and the 10-year Treasury yield shot from below 1.7% to above 2.7% at lightning speed. Many FOMC members were quite startled by this response and were fearful of its potential impact on the economy. They need not have worried.
Insights from forward guidance mistakes
The problem with forward guidance is not the concept but the implementation. On this score, the Bernanke Fed did quite poorly. At first, it tried clarifying its policy intentions with a calendar-based timetable. This did not work, largely because market participants understood that the economy is dynamic and that timetables are likely to change. Then, in 2012, the Fed shifted to specific, simple economic indicators to explain its policy intentions. Yellen discussed the issues and this transition in a well-known speech in June 2012 at the Boston Economics Club. The shift came in late 2012 when Bernanke declared that achieving a 6.5% unemployment rate would be associated with a discussion of possibly ending QE. Immediately, it was clear that indicator-based guidance was as badly flawed as its calendar-based predecessor. Many market participants interpreted the 6.5% unemployment rate as a trigger, and, as a result, Bernanke and other FOMC members had to hit the speech circuit to explain it was nothing of the kind - effectively gutting their message from start.
Market participants are looking for the Fed view on the economy and inflation
Calendar and indicator methods of forward guidance are fatally flawed because they are technical approaches to a holistic problem. Under Bernanke, the QE signaling was decidedly pessimistic; because the message was that the economy was so fragile it needed untried emergency life support measures. When the "Taper Talk" began, the stock market took off over the rest of the year to new highs after new highs, because the Fed's message finally became optimistic - the economy is healthy enough not to need QE. And, to the surprise of many FOMC members, the equity market was not at all perturbed by the 100 basis point rise in the 10-year Treasury yield, we think because of the confidence-building signal received.
Given these experiences, the Yellen Fed may choose to back away from using explicit indicators to signal future intentions. Moreover, as economic growth improves, the focus of public attention to the Fed's views may also shift gears. We expect Fed signaling about its inflation outlook to become more important. Market participants will continue to look to employment data to confirm Fed views on economic activity, but with even a whiff of inflation, trading activity around consumer and producer price data may become much more interesting as well.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.