A Breakdown in the Narrative

A Breakdown in the Narrative

After dropping interest rates to zero and beginning to buy what would become trillions of dollars in bonds, the Federal Reserve was in need of new, creative tools to conduct monetary policy. What the Fed pursued was the now all-important “forward guidance.” This is the art of telling people about the path of future monetary policy actions. And it became a powerful weapon in the Fed’s limited post-crisis arsenal. But forward guidance may now be coming back to haunt the Fed.

To a degree, the purpose of forward guidance is to control the narrative, to control what people understand and discuss. The Fed wants to be the one creating the economic narrative. It doesn’t want Wall Street or politicians doing it.

So, the Fed has articulated its view of the economy and driven the economic dialogue. It did this by increasing the number of speeches and interviews given and attempting to be radically more transparent about its policy intentions than in the past.

But this is becoming a problem for the Fed. With big changes coming in the upper echelons of leadership, there is less useful content being transmitted than normal. There is little question that it may be counterproductive at the moment. After all, only three of seven positions are currently filled on the Board of Governors. And Chair Yellen’s term comes to an end in January. That is five powerful positions to be filled in the next few months. Five out of eight.

So, the people giving the speeches now may not be around to deliver on the stated policies. There is no intentional harm being done, but that does not mean real, tangible harm is not being done by the continuation of the speeches and guidance.

The Trump administration will fill at least some of these positions in the near future. This will lead to a new makeup of the Fed. And with it—potentially—the economic narrative itself.

For perspective on the extent of its usage, this year is likely to see the average Federal Open Market Committee (“FOMC,” the committee that sets monetary policy) participant give around 13 speeches. That is roughly twice as many as just ten years ago. This amount of forward guidance has been a useful tool for guiding markets about the Fed’s intention for changes (or lack thereof) in future monetary policy.

It could even have been necessary, due to the zero interest rate policy and quantitative easing. Since the onset of the financial crisis, the Fed has had to lean heavily on its forward guidance arsenal. This is because cut interest rates and had already purchased trillions in assets.

And to the Fed’s credit, markets have become addicted to hearing the Fed’s commentary and its intentions. This was particularly evident in the most recent FOMC press conference. Chair Yellen was asked about what could alter the Fed’s path to reduce the balance sheet, and she gave a straightforward answer: a crisis.

Is that really the truth? To be fair, that is probably the thinking of the present Fed. However, the current Fed is different from what the Fed will be in 2018 and beyond. The future Fed could easily pivot toward reducing its asset holdings more quickly than planned. Or the Fed might slow it in reaction to an unforeseen negative economic event. This is the crux of the problem of using forward guidance to steer the narrative. When the Fed’s members change out, so too does the narrative.

Granted, Yellen and the FOMC succeeded in guiding markets toward the likelihood of a rate hike in December that the market appears to have been overlooking. This gives the Fed more room to navigate policy and is a positive.

On a more confounding front, there are still forecasts of three rate hikes in 2018. Again, this talk of rate hikes beyond December is irrelevant. The Fed in 2017 will be very different from the 2018 Fed. The authors of the new narrative have yet to pick up their pens.

The question that markets should be asking is how the narrative is likely to change. Will it be a wholesale rewriting or simply an incremental change? Nobody knows for certain. It appears some new FOMC members are more hawkish than the current ones. They want higher interest rates, but we simply do not know how much higher the rates, or the timing of the hikes.

Of course leadership will matter as well. And where they want to take the narrative will hold significant weight.

Regardless, changes are coming to the narrative. It will take some time to alter it, and there is no way of knowing how easily or subtly it will shift. A harsh, dramatic pivot has a different consequence from a slow, measured approach. The truth of the matter is that there is a regime change coming to the Fed. And with it, a new narrative. Few observers understand the danger of changing from one narrative to another. It is a policy crisis of the Fed’s own making.