In the 10 years since the worst days of the global financial crisis, the Fed has used all manner of unconventional tools and language in an attempt to guide the economy and market towards self-sustainability. During this time, much debate and analysis has taken place about the meaning of a word or phrase, whether it should be interpreted as hawkish or dovish and what it means for the future path of monetary policy. With investors conditioned to analyze the FOMC’s every word, the Fed’s current challenge has been to simplify and to gradually reduce the market’s dependency on forward guidance and get back to more “normal policy”. For now at least, it looks like the communication strategy of the crisis era is going the way of the dodo.
In this blog, rather than debate the relative hawkishness or dovishness of recent Fed speak, we would like to take a step back and look at the Fed’s communication strategy as a whole, what it means for future policy and what it means to get back to “normal”. In totality, we view the evolution of the Fed’s communication as logically sound and consistent with where the US economy is in the business cycle and the proximity of monetary policy to the zero lower bound. As President John C Williams of the NY Fed stated earlier this month:
“Now that interest rates are well away from zero and the economy is humming along, the case for strong forward guidance about future policy actions is becoming less compelling…. At some point in the future, it will no longer be clear whether interest rates need to go up or down, and explicit forward guidance about the future path of policy will no longer be appropriate.”
The Fed’s strategy to normalize communication appears to be focused on three main areas. The first is to emphasize the self-sustainability and strength of the US economy. To that end, the FOMC’s confidence about the US economy and their ability to sustainably reach their objectives of maximum employment and price level stability has risen notably. Mentions of the word “strong” and “strength” within the FOMC Minutes have surged in 2018 to 42 mentions in the September minutes. Indeed, earlier this month, Chair Powell described the US economy as experiencing a remarkably positive set of economic circumstances.
The second area of focus has been to characterize policy in a more “humble way”. This means to express less confidence in their ability to forecast and to stress uncertainty around the longer-run. The benefit of wider confidence bands around long run estimates such as the natural rate of unemployment and the long run neutral fed funds rate is to avoid sending a message of false precision which will have to be walked back when they ultimately have to revise their estimates. A more humble Fed is also closely connected to a more data dependent one. As data evolves either with or against their expectations, a Fed with less confidence over the long run is more likely to adapt to what current conditions are telling them. Again returning to Williams to best summarize this approach:
“Whatever the future may bring, I will be guided by our dual mandate, a heavy dependence on data, and a steadfast commitment to transparency”
The third area of focus for the Fed has been making an intentional effort to reduce the length of FOMC statements and remove the old remnants of forward guidance from their vernacular. As shown in the chart below, FOMC statement length peaked in 2014 as the Fed ended QE3. At the peak of forward guidance, the phrase “considerable time” was used to assure investors that they wouldn’t start raising rates immediately after the end of QE3. This assurance, which originally comforted markets, was lost when Yellen attempted to define the phrase prematurely as “something on the order of around six months”. Now that we’ve moved over 200bps away from zero on the Feds Funds rate, FOMC statement word count has dropped significantly.
While the Fed is providing more color around current economic conditions and their reaction function to changes in current conditions, they are providing fewer explicit promises or expectations about where policy will proceed in the future. For example, how do we interpret the Fed’s recent removal of the sentence in the statement that “the stance of monetary policy remains accommodative”? This too was part of the same playbook we have been discussing. The change was not a signal of hawkishness or dovishness, but an opportunity to remove language that could ultimately send an unnecessarily explicit signal about future policy. This is timely given the considerable uncertainty about how much more the US economy can handle in terms of additional rate hikes. Moreover, the SEP (dot plot) already shows that all estimates of the long run Fed Funds rate are above the current level of the policy rate, hence policy is still accommodative.
What else can we gleam from this normalization of the Fed’s communication strategy? As the Fed has expressed more confidence in growth and less certainty on how many more rate hikes are left in this cycle, the US Treasury market has reacted. Since August, the 10yr yield has moved 40bps higher and the real yield curve has moved steeper. Our interpretation of this move has been one of a repricing higher in real growth expectations and increasing term premium (or uncertainty) around longer run rates. The relationship between the quantity of Fed speak and term premium has evolved over time. In fact, over the past decade, increases in the word count of statements have coincided with increasing term premium. Consider the rise in volatility around the Fed’s exit from QE3 which also coincided with a notable uptick in verbal direction from the Fed about how exactly the exit would occur and when. More recently over the past two years, the experience has flipped where less Fed speak has actually resulted in higher term premium. The reason for the inversion in this correlation is that the Fed shifted regimes from an easing bias to a tightening one. In the current tightening regime, a negative correlation (less Fed speak, higher term premium) is one we would expect to remain going forward as the Fed gets further away from the zero lower bound but also becomes less precise about how much further they can go, causing increasing volatility and a normalization in term premium.
We would be remiss not to mention that eventually the pendulum on Fed communication will swing the other way in the next recession. At that point, we expect forward guidance to rise forcefully from the ashes as a powerful policy tool to influence financial conditions in the absence of traditional methods of stimulus. Remember that the dodo was a type of dove, but unlike the dodo, this dove could come back to life.