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LONDON, June 15 (Reuters) – While the U.S. Federal Reserve’s plans change from week to week, the concept of “forward guidance” as a policy tool has well and truly been abandoned.
The latest of this year’s financial market quakes is a snapshot of how one of the three main levers of monetary policy was trashed out of necessity and, probably, choice.
Just three months ago, on March 4, Fed chief Jerome Powell told reporters that an outsized 75 basis point interest rate hike was not something the political committee central banks were “actively considering” as part of its planned round of rate hikes to curb 40-year high US inflation.
Still, markets this week feel like they’ve been pressured at the last minute to assume that the Fed will make its first three-quarter-point U.S. rate hike since 1994 on Wednesday after a series of slightly bizarre events following the announcement on Friday of a surprising acceleration in consumer price inflation last month.
While interest rate and bond markets were somewhat jolted by the inflation numbers themselves, Fed officials were in their traditional “purdah” period of silence ahead of the meeting.
But all hell broke loose when Wall Street Journal Fed watcher Nick Timiraos reported on Monday that Powell and Co would actually “consider” a 0.75% move this week – contrary to another article. he wrote this weekend.
The entire bond complex collapsed and was forced to reassess an entirely new and lofty Fed trajectory starting this week to a high of around 4% peak rate by March of l ‘next year. Stock markets plunged around the world and the dollar surged.
Among other things, Goldman Sachs economist Jan Hatzius instantly changed the bank’s forecast to assume a 75 basis point move in Fed rates this week and next month – quoting the WSJ article as ” an unofficial hint of the Fed’s direction,” Friday’s inflation print and pick-up in household inflation expectations.
Whatever the ultimate outcome, the last-minute guessing game and nervous decision-making – assuming the Fed is involved – is a stark departure from years of “forward guidance” designed not to shock markets. , improve transparency and allow investors months or years to absorb changes in policy direction.
The implication for investors is that the deliberations of the Fed and those of other central banks will become much less predictable in the months and possibly years to come, implying greater uncertainty and volatility on the horizon and will require higher risk premia to compensate.
As short-term and long-term US Treasury yields climbed above 3% on Monday and the harbinger of recession in the 2-10-year yield curve reversed again, the The MOVE index (.MOVE3M) of Treasury volatility recorded its biggest one-day jump since the seismic March of 2020 when the pandemic hit and now stands at its highest level since 2009.
And the ever-negative “term premium” – which suggests that investors require no additional compensation for holding long-term bonds to maturity versus rolling short-term bonds for the same period – could be the next to give in as the Fed unwinds its gigantic sheet bond balance over the next year.
While many are now wary of what the Fed’s new economic forecasts will reveal this week, the old phrase “data dependent” comes up again and again.
It’s usually pretty benign. But given some of the extreme economic distortions from the pandemic restart and the war in Ukraine and the uncertainties around energy and good prices, it could lead to some wild recalibrations before the Fed and other central banks will think from month to month.
Thomas Costerg of Pictet Wealth Management believes the Fed’s reaction function has become “retrospective”, panicked by past high inflation and prone to political pressure.
Pimco economist Allison Boxer also thinks 75 basis points is now possible this week and believes the Fed will continue to climb beyond September, creating a “serious risk of excessive tightening.”
But “forward guidance” long into the future has been heavily criticized by many economists as a reason why the Fed and other central banks have been so slow to normalize interest rates as economies recover from the recession. pandemic and inflation was rising last year. Parking it a bit may be deemed necessary.
Forward guidance as a quasi-formal policy instrument has only been truly codified in the last 15-20 years as another means for central banks to influence long-term borrowing rates and expectations of the market – mainly over the past decade, when policy rates ran short of near zero while deflation was still looming. It acted as a complement to buying bonds as a way to keep traction on long-term rates.
The polar opposite was true as recently as the early 1990s. Not only did the Fed play its cards close to its chest, it often took more than 24 hours to read the runes of open market operations to determine if the policy had changed.
Let them guess was also a mantra around the world. German Bundesbank insiders advocated telling the markets clearly how they were formulating policy, but “not what we are going to do tomorrow.”
Now that the risks of deflation and the “lower zero limit” problems of the past decade are over, guiding the markets on higher interest rates is almost a new business.
And yet, the first pangs of the Fed’s forward guidance during the early 2000s tightening cycle – when two years of well-signaled quarter-point rate hikes pushed policy rates from 1% to 5, 25% in mid-2006 – were also blamed for suppressing volatility and spurring the excessive risk-taking that plagued the crash of 2007/2008.
Should it clearly guide long rates but not policy changes?
With an unwinding of the Fed’s balance sheet also in the mix, the Fed could see a compromise between the two to handle a very bumpy ride ahead.
The author is Finance and Markets Editor at Reuters News. All opinions expressed here are his own.
by Mike Dolan, Twitter: @ReutersMikeD. Editing by Jane Merriman
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