The Federal Reserve, in its 12 December policy release, made a significant change to its communication policy that is likely to have the unintended consequence of greater market volatility. Prior to this meeting, the Fed used calendar guidance – stating it "anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.”
This date-based guidance was replaced with language linking future policy to economic variables instead. Specifically, the Fed: "…anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 per cent, inflation between one and two years ahead is projected to be no more than a half per centage point above the Committee’s 2 per cent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
The Fed’s motivation for the change in course is well-intentioned and has some appealing qualities relative to the previous approach. First of all, with the new guidance the market is able to better predict how the Fed will react to a change in incoming data. As the economic situation improves (or deteriorates) the market can, on its own, adjust expectations regarding the expected lift-off from zero interest rate policy to a shorter (or longer) period of time from now without explicit guidance from the Fed.
The previous calendar guidance troubled the 'doves' on the Fed because whenever the Fed had to extend the date it unintentionally sent a message to the market that the Fed had downgraded its economic outlook – when in reality the Fed did not intend to suggest that the outlook had deteriorated, but simply that it hadn’t improved enough to suggest higher rates were imminent. This feature of extending the calendar date created an adverse-feedback loop. Likewise, the 'hawks' on the Fed disliked the calendar guidance because in the event the economy improved unexpectedly, the Fed could find it difficult to withdraw policy accommodation at an appropriate pace, introducing the risk of substantial inflation. In a rare 'bipartisan' compromise out of Washington DC, in the current polarised climate, two sides of a negotiation found a win/win solution.
Or did they?
Critics will claim that the Fed is trying to apply a too-precise model to a problem it doesn’t fully understand how to diagnose. Cynics will point out that since one of the variables the Fed is targeting (inflation) is not based on actual inflation but rather projected inflation that the Fed controls itself, it is a bamboozle – as well as a thinly veiled attempt to prioritise the employment side of its mandate ahead of the inflation side. But right or wrong, the Fed has taken the markets one step further down the path of experimental and untested policy. And markets may soon discover this latest step to prove counter-productive to one of the Fed’s other objectives – the suppression of market volatility.
On August 9, 2011 the Fed introduced calendar rate guidance – initially targeting 'mid-2013' – in an attempt to assuage markets in the throes of debt-ceiling generated volatility. The policy move worked brilliantly. In the subsequent seven trading sessions, the VIX index declined from 48 per cent to 32 per cent and the MOVE Index of interest rate volatility declined from 118 to 88. The trend lower in both volatility markets has been maintained essentially ever since. The logic behind the Fed’s move was to reduce market uncertainty regarding future Fed policy – to assure markets that the Fed’s steady hand on markets was not going away anytime soon. In doing so, market volatility was suppressed, term-premium in yield curves diminished, risk-premium in equity markets reduced and investors were generally encouraged to take more risk.
To be fair, the Fed clarified in the minutes to that FOMC meeting that the guidance was conditional and that if economic data improved, the Fed maintained "flexibility to adjust the policy rate earlier.” However, markets perceived it to be much more of a commitment than a forecast. Perhaps the Fed’s proposal was not of the 'married-with-children' variety, but it was thought by most to be at least an 'engaged-with-commingled-bank-account' degree of commitment. With its recent communications change, the Fed has downgraded its relationship status with zero interest rate policy to 'until-something-better-comes-along'.
And that something better is an unemployment rate that has sneakily declined from an October 2009 peak of 10 per cent to the most recent reading of 7.8 per cent, and at the recent pace it will be less than the Fed’s 6.5 per cent threshold for considering raising rates before mid-2015. However, PIMCO’s New Normal growth forecast indicates a much slower rate of descent in the unemployment rate than that. Furthermore, we believe if unemployment does, indeed, experience such a sharp decline it is more likely to be driven by a continued decline in the labour force participation rate rather than real output gap compression. Nonetheless, incoming economic data will increasingly matter more to investors as they calibrate future Fed policy.
We expect increased market volatility under the new communication regime, particularly around economic data releases. Investors with an understanding of the Fed’s now increasingly transparent reaction function will find opportunities to profit in the volatility markets.
With calendar date guidance, interest rate markets largely shrugged off employment data – with the Fed tied to a date, a few tenths of a percentage point on the unemployment rate did not materially change the perception of future Fed policy. Now, however, incoming data is more critical and will drive market volatility. According to our model of the Fed’s reaction function, presently every ¼ of a per cent unexpected change in the unemployment rate is likely to lead to roughly an 11 basis point change in the five-year Treasury yield.
This relationship will become even more sensitive should the unemployment rate continue to decline. Additionally, markets will need to deal with the subsequent volatility driven by the debate over whether the unemployment rate change was driven by real economic or transitory factors and the third-order effect of the Fed communique ratifying or contradicting the market’s interpretation. The equity market will have to battle with a push and pull of its own – one that characterises markets dependent upon monetary policy. On the one hand equity markets benefit by signs of an improving economy but on the other hand equity markets are hurt by the prospect of sooner withdrawal of monetary accommodation and rising policy rates.
The Fed’s new communication strategy may, in fact, be a more sensible policy prescription than calendar rate guidance. However, the likely unintended consequence of such a move is a heightened level of market volatility, which could undo some of the hard fought progress the Fed has made in influencing asset markets and risk-taking behaviour. We believe investors should expect an end to the now eighteen month old trend lower in market volatility.
Josh Thimons is a managing director and portfolio manager in Pimco's Newport Beach office.
© Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved.