The Federal Reserve missed another opportunity to raise rates late last month. I know what you are thinking. Rates were never going up. We all know they will warn us for weeks before pulling the trigger – and besides, there was no press conference, and rates never change unless there is a press conference.
But this is precisely the problem. The Fed’s script has become so predictable over recent years – and predictably wrong – that no one really listens anymore.
Last month’s statement was no cut-and-paste from the month before. There was hawkish new wording about near-term risks having ‘diminished’, and ‘strong’ job growth and household spending. But markets pushed Treasury yields down – the opposite of what one might expect. Fed Funds futures did raise the implied probability of a rate hike in December, but you needed a microscope to see it.
Since the bungled messaging around the Jackson Hole conference in August last year and the subsequent FOMC meeting in September, we have been urging investors to ignore what the Fed says and focus instead on what the market predicts it will do. Markets have proven better forecasters of how stalling productivity growth and the global economic slowdown would work their way into US monetary policy.
This matters because, for central banks to maintain control, they need messaging to be strong enough to lead markets.
Lessons of history
To understand how we got here, it is helpful to go back to the summer of 1982, when I was a trainee at Salomon Brothers and Paul Volcker was in the chair at the Fed.
Things were different then, and not only in the sense that overnight rates were at 20% and inflation was running at 12%. Volcker’s policy was innovative, radical and aggressive enough to beat inflation and usher in the bond-market bull that charges to this day – but it was also non-transparent to the point of being mysterious. FOMC members did not drop hints on 24-hour news. We understood short-term money supply was important, so we would hang on that data once a week and T-Bill rates would gyrate wildly, literally by hundreds of basis points.
The 1980s Fed could shock markets into obedience, and it worked: By the time Volcker retired, inflation was at 3%.
The ‘great moderation’ he bequeathed enabled Alan Greenspan to pursue a more measured approach. Part of that was introducing greater transparency and guidance. As a believer in efficient markets, his view was he could mitigate market and business volatility by giving people more information.
But Greenspan’s ideological imperative grew into a necessity under Ben Bernanke and Janet Yellen.When interest rates approach zero and QE loses traction, messaging quickly becomes the only effective policy tool left.
And yet, the last time the Fed was able to rattle markets with its messaging was three years ago, when Bernanke set off the ‘taper tantrum’ by warning of tighter policy on the way. Since then, the Fed has raised rates once. If you cut your teeth in the Volcker era, it is pretty sleepy stuff. No wonder the markets have tuned out.
The Fed needs to be brave
That is worrying. My hope is to see a Fed courageous enough to surprise the market again – and I suspect that circumstances may one day force the issue.
After all, the European Central Bank and the Bank of Japan still occasionally show us how it is done. Late last month was the fourth anniversary of Mario Draghi’s ‘whatever it takes’ intervention – the ultimate in central bank policy-by-messaging. Its announcements in March this year approached those heights, too, as did the Bank of Japan’s plunge into negative rates.
That aggressive and shocking action was forced by the precarious states Europe and Japan were in. By contrast, the Fed has for too long been in a too comfortable position, with decent job creation and some growth and inflation.
With that in mind, last Thursday’s media comments from one of the leading characters in our story bear repeating. Alan Greenspan attributed slowing productivity growth to the impact of an aging society on entitlement spending, which he argued is crowding out investment. As long as politicians remain unwilling to address this, economies will continue to stagnate. At the same time, however, Greenspan warned about signs of inflation.
If Greenspan is right and we are seeing the beginning of an era of stagflation, the great bull market in bonds could be about to end. The Fed may have to turn its focus back to inflation again, rather than growth stimulation – as well as do things that are radical and aggressive enough to surprise the markets. How radical will it need to be to regain the market’s attention? This is a good question.
Brad Tank is chief investment officer – Fixed Income at Neuberger Berman