Is There a Central Banker in the House?


David Gothard

This week’s statement from the Federal Open Market Committee has yielded further insights into who’s running monetary policy in the U.S. It’s not who you think.

Immediately after Federal Reserve Chairman

Jerome Powell’s

Wednesday news conference, economic commentators and traders convened on television, on news websites and in emailed research notes to investment-bank clients. These folks decided, in real time and before our eyes, what they thought he meant. Their decision, as reflected in changes to asset prices and bond yields, then became the FOMC’s de facto monetary policy. The tail and the dog wagged each other at the same time.

This happens because central banks everywhere have come to rely on “forward guidance”—communication to investors about the likely future path of monetary policy—as one of their primary policy tools. Aside from occasional forays in the 1970s and ’80s, the Fed started experimenting with forward guidance in earnest in the early 2000s.

Under Chairman

Alan Greenspan

the Fed felt investors had overreacted to its increase in the short-term policy rate in 1994, after which 10-year Treasury yields surged by nearly 2 percentage points in five months. Ahead of a rate increase in 2004, the Fed experimented with a new policy of simply telling investors what it thought they should do by informing them what the central bank might do in the future.

This rationale is worth parsing because it’s so inappropriate. Financial markets exist to digest uncertainty. Policy makers’ insistence on shielding investors from uncertainty about the course of policy, or anything else, has denatured markets in pursuit of the Fed’s attempts to manage longer-term interest rates. These rates ought to be an exclusive preserve of the market, as a signal of investors’ expectations of the economy’s future.

The Fed’s forward guidance has only grown more important in the years since the 2008 financial panic because it has become an explicit tool in the Fed’s policy-making box alongside a near-zero short-term rate and asset purchases. It’s yield-curve control by word of mouth, talking investors into generating the Fed’s preferred low long-term rates. The central bank can try to impose its will on all points along the yield curve while pretending “the market” is in charge.

Which brings us back to Wednesday. What actually sent bond yields fluttering and stock markets sinking was . . . nothing. There was no change to short-term rates other than a modest increase to the rate the Fed pays on banks’ excess reserves. There was no change to the Fed’s monthly purchases of $80 billion of Treasurys and $40 billion of mortgage-backed securities.

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These omissions are borderline reckless given the state of the economy. Inflation is roaring ahead, to the point where even Fed policy makers have raised their prediction for this year to 3.4%, and there’s growing reason to worry rising prices may not be transitory. Near-zero rates and asset purchases were sold as a response to the pandemic emergency. With Covid-19 fading and the economy’s health improving, shouldn’t the Fed be returning quickly to normal—or at least to a slightly less abnormal—policy stance?

Wednesday’s news conference also didn’t provide any credible substantive guidance on how the Fed will set rates in the future. Reporters and economists talk about the Fed’s “dot plots”—showing the course individual FOMC participants expect short-term rates to follow in coming years—as if they mean something. They don’t. This week’s dot plot suggests modest rate increases by the end of 2023. How committee members think they can project with any certainty the shape of the economy or appropriate monetary policy in 2½ years is a mystery. And everyone knows it.

Mr. Powell thinks the market will overreact if the Fed offers more-meaningful guidance about what it will do. That’s what happened eight years ago this week when Chairman

Ben Bernanke

was relatively specific about the circumstances under which the Fed might start to slow the quantitative-easing program of the day. Investors sent the 10-year Treasury price tumbling.

Mr. Powell has acknowledged that this “taper tantrum” was one of his formative experiences as an FOMC member. As a result, his Fed tries to create a mood rather than convey meaningful information when it issues forward guidance. Dot plots are about emotions, not facts.

Emotion-management is particularly fraught surrounding a possible reduction in the Fed’s monthly bond purchases, which explains another oddity of this week’s FOMC events. At his press conference, Mr. Powell spoke off the cuff when he fielded journalists’ questions about inflation expectations, unemployment and the like. The one exception was the inevitable question about tapering. He appeared to read that answer carefully from a prepared text, and it sounded like a hostage statement: “You can think of this meeting as the ‘talking about talking about’ meeting, if you like. . . . The economy has clearly made progress, although we are still a ways from our goal of substantial further progress. . . . Assuming that is the case, it will be appropriate to consider announcing a plan for reducing our asset purchases at a future meeting.”

It sounded like a hostage statement because Mr. Powell is a hostage—to the market. The Fed adopted forward guidance to reduce volatile market reactions to its policies. Having made reduced volatility a policy goal in its own right, the central bank now is judged on how successfully it soothes investors’ frayed nerves. This is neutering the Fed. Since policy makers are no longer willing to surprise markets, they aren’t willing to act quickly when conditions change. Increasingly they find they can’t offer substantial forward guidance, either.

The Fed didn’t feel able to taper asset purchases or raise the short-term interest rate this week. Would it have felt differently if markets had been left to their own devices and already priced in guesses about such a move in response to data everyone can see? It makes you wonder who, if anyone, is in charge of monetary policy in the world’s largest economy.

Wonder Land: Emmanuel Macron welcomed Joe Biden to “the club.” He was talking about the European welfare state. Image: Kevin Lamarque/Reuters

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Appeared in the June 18, 2021, print edition.