Has The Fed Acquired Too Much Power? Yes. Dump Forward Guidance

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Includes: DIA, SPY
by: Kurt Dew

Summary

The Fed’s “forward guidance” was useful during the Crisis.

But it now has a greater effect on markets that does a change in the policy rate.

This reduces Fed accountability.

It is time to dump forward guidance, a dangerous relic of the Crisis.

Once upon a time the Federal Reserve was a circumspect organization. The FOMC reported its plans once a month. The Chairman was occasionally asked to testify. That was about it.

Wow! How that has changed! Soon we will be requiring each of the members of the Federal Open Market Committee to submit to a weekly psychological evaluation. And we will be publishing the results, with transcripts. Too much information! "Why?" we ask.

Does all this understanding of the inner thoughts and ambivalences of various Fed officials improve our economy's performance? Does it make trading securities less risky? No. Market values, as embodied for example in the S&P 500 (NYSEARCA:SPY) are damaged by the uncertainly caused by the obscure and conflicting information resulting from too many vague references to an excess of variables that are "closely monitored."

More disclosure of factual information about monetary policy, a central responsibility of our government, makes it more transparent, which can't be all bad. But there are limits.

I suggest that you can look at the desperate times of the Crisis, and the Machiavellian genius of former Chairman Bernanke, for an explanation for all this talk.

Chairman Bernanke with a Single Policy Instrument

Former Chairman Bernanke was appointed for his highly regarded knowledge of economic policy in situations of extreme economic stress. Once he assumed office, I quickly appreciated his ability to scheme where just a plan was not enough. He and the FOMC quickly moved the policy rate to zero. A lesser man might have thrown up his hands at that point, thinking he has used his power to the maximum, leaving nothing more to do.

Not Chairman Bernanke. What others thought of as anachronisms of the Fed's custom, Bernanke saw as weapons. Soon he was not a Chairman that had spent his policy ammunition, but he had seized two new weapons. He had learned the lesson of the Depression, when the Fed, worried (unbelievably) about possible future inflation, "sopped up" large amounts of excess reserves and deepened the banking crisis. He instead encouraged the banks to hold excess reserves, converting excess reserves it into a tool of expansion that simultaneously made the financial system safer.

Then he took an innocent clause found in the FOMC directive, that discussed the possible future decisions of the FOMC, called "forward guidance," and turned it into another policy tool, when he promised a protracted period of future zero policy rates

Now he was no longer a zero tool powerless Chairman; he was a three tool Super-Chairman!

Chairman Bernanke with Three Policy Tools.

Forward guidance may have had the objective of being informative before the Bernanke transformation. But what it has become today is part of our government's understandable, yet undesirable, attempt to exert more control than we have asked them to provide.

The Fed's release of its policy rate decision made at FOMC meetings is, of course, information the market requires. But do we need to know more than that the current policy rate is 0.25%-0.50%?

Now I find forward guidance and the other "ifs, ands, and buts" of the directive distracting at best, and at worst, a power grab. By that I mean that the FOMC is attempting to do more than it claims to be doing.

I believe I finally lost patience with forward guidance when the work "patient" became a market-mover. The appearance of this word in Fed reports until the March 2015 was supposedly a signal that the Fed would wait at least one more meeting before increasing the policy rate. But as we all know now, throwing "patient" out of the Fed's directive did not result in a policy rate change. That happened later in December.

In these more normal times we should be returning to a one weapon monetary policy arsenal.

Chairman Yellen with Three Policy Tools.

Monetary policy now moves markets without changing the policy rate due to the other policy tools, excess reserves and forward guidance, which seem different every day.

Nobody really knows what changes in excess reserves will do to the economy. We have long ago learned that the level of reserves in the banking system has a tenuous relationship to economic performance, at best, during normal times. This understandably desperately needed weapon during the crisis should be gradually retired.

But the second tool, forward guidance, is a more urgent matter. This weapon has become very divisive. Supposedly with no official significance, researchers comparing effects of the two instruments, the official policy rate and forward guidance, find (among other things) that the effect of a change in forward guidance is more important than the effect of a change in the policy rate on long term rates. Not only is it a sub rosa policy tool; but it has become more important than the official policy tool!

That puts the Fed in a position to say it is doing one thing while actually doing another. A 25 basis point increase in the policy rate followed by three more increases this year is obviously going to have a greater effect on the economy than a simple one-time increase of 25 basis points. And the forward guidance is wishy-washy. It increases uncertainty because the markets know it's a feeling, not a fact.

We want facts from our government, not feelings. If the Fed intends to change the average policy rate by 50 basis points in 2016, there is a simple objective way to do that. Change the policy rate by 50 basis points. Replacing that objective, debatable, decision by a non-decision, forward guidance, is replacing real decisions with an exercise in mind reading. No thanks.

The Fed needs only one instrument. The policy rate is tangible and the Fed is accountable for its choice. All the rest is obfuscation - a power grab that avoids the associated responsibility.

I suppose it is hopeless to expect the Fed to just tell us the new policy rate. A reasonable investor or person otherwise concerned about our economy wonders what the FOMC considered salient economic, or even non-economic, forces that led to the decision. Said another way, we would reasonably like to know why the Fed's decision was made.

I concede that during the depths of the crisis, when the policy rate was zero, a statement that it would likely stay at zero for some time was useful. It told observers two important things.

  1. The Fed had no intention of reducing the policy rate below zero.
  2. The zero rate was no experiment. There was a commitment to remain at zero.

But those desperate days are over. Less scheming. More truth.

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.