Federal Reserve Not Only Creates Volatility, But Also Adds To It

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Includes: IWM, SPY, URTH
by: John M. Mason

Summary

Forward guidance is proving to be the trouble maker in the Fed's arsenal of weapons.

For one, forward guidance requires accurate forecasts of the future. How can a central bank provide forward guidance about the future if its forecasts are wrong.

Policies of a central bank must be appropriate for the times. The Fed is hampered by the out-of-date policy objectives imposed by Congress, based on an out-of-date economic model.

At one time in its history, the Federal Reserve attempted to act in a way that contributed to calm markets but that also helped achieve smooth, incremental transitions from one market situation to another. It was not always successful, but volatility was substantially below what we are accustomed to today. Now, the Fed, itself, seems to be one of the major causes of market volatility, but then seems to only add to the market volatility created elsewhere.

The reason? Forward guidance!

Forward guidance really was put into place in the Bernanke-led Fed as Chairman Bernanke pushed for ways to convince financial markets that the Fed was going to keep interest rates low for "an extended period of time." It seems as if Bernanke and the Fed believed that it needed to be extraordinarily persuasive that it would keep interest rates at very low rates in order to convince investors that the Fed would do all it could to get the US economy moving again.

Mr. Bernanke describes the scene in his reprise of the events leading up to the Great Recession and beyond in "The Courage to Act: A Memoir of a Crisis and Its Aftermath."

There may be some times when forward guidance may work, but my belief is that there are really very few times when it will actually work. Why? Well, first because one must be able to predict the future accurately. Second, because one must also be able to come up with an appropriate policy. If the Fed cannot forecast correctly, then how can it provide forward guidance?

In late 2014, soon after the third round of quantitative easing was ended, officials at the Federal Reserve predicted that the US economy was going to get stronger, that employment conditions would continue to improve, and US inflation, impacted by the price of oil and world commodity prices, would soon turn around and return back toward the Fed's target rate of 2.00 percent.

As a consequence, officials at the Fed signaled that it would probably raise target short-run rate of interest by the end of March. The US economy seemed relatively strong in the first part of the year and the employment figures continued to improve...although labor forces participation rates remained low...but there seemed to be no pickup in inflation.

And, March came and went, and the target date was pushed back until June. Employment figures continued to improve, modestly, the economy reached a year-over-year high of about 2.9 percent in the second quarter, but inflationary expectations in the financial markets moved opposite of the Fed's inclinations. June did not seem to be quite right for a move...maybe the fall would be better.

Well, modest improvements continued to the labor markets although the labor force participation rate remained near its 50-year low. Economic growth got weaker in the third quarter, and inflation continued to wane with market expectations falling even further.

Then, there was the Chinese devaluation of the renminbi and the growing reports of even further slowdown of the China economy. Oh, and then there was the growing tension in the Middle East, the more pronounced efforts of Russia's Putin in the world, and the continued collapse of oil and commodity prices.

And, the fall went by and December was looked on as the next possibility. But the Fed had put itself into a corner it could not get out of. With the US economy continuing to slow, with inflation prospects looking weaker and weaker and with relatively strong labor numbers, officials at the Fed seemed to act out of desperation...something you don't want your central bank to do...to finally make the move on interest rates it had promised to make throughout the year.

And, then what happened? Talk started almost immediately about when the Fed was going to have to reverse itself and reduce its policy rate.

The Fed's response? Well. In 2016, officials at the Fed signaled the central bank will probably raise interest rates four times during the year, a quarter-point each quarter. It was as if the officials at the Fed had learned nothing all year. But, the die was cast...and the discussions began all over again. Right now, it seems extremely difficult to picture the Fed making one increase this year, let alone four.

Secondly, there is the question about the Fed choosing the correct policy.

Historically, the Fed has been following the policy objectives given to it by the US Congress...to keep unemployment low and to keep inflation low. These are goals of a sovereign nation that is independent of all other financial markets in the world.

The situation of the United States this past year is that it was one of the better growing economies in the developed world. Its economy was growing at a compound annual rate of growth of 2.2 percent since the recovery began in 2009, not great but much better than all other major industrial areas of the world.

As a consequence, its monetary policy was "out of sync" with the other major central banks of the world. It has been the case that the strength of the US economy and the weakness elsewhere has helped to make the US dollar a stronger and stronger currency.

The policy stance, taken in late 2014, has only exacerbated the situation. On any wave of enthusiasm for an increase in the Fed's policy rate, the value of the US dollar rose. As news that it was less likely for the Fed to move, the value of the dollar fell. Volatility increased in step as expectations built up and receded.

The thing about a stronger US dollar is that it hurts US exports and causes the US economy to be weaker and the profits of US corporations to be weaker.

Also, a nation can only maintain a strong currency if it is willing to take on a world leadership position, economically, something the United States does not seem prepared to do. The emphasis on continuing to raise its short-term policy rate, which the Fed reconfirmed today, is neither consistent with this leadership nor the state of the world economy.

Given the strong market response to the Fed's statement, all I can say is that the Fed-caused market volatility is here to stay for quite some time. The Fed is adding to a chaotic world, not one that is more ordered.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.