Fed Forward Guidance Increases Market Volatility

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The Federal Reserve’s forward guidance program was a disaster, so much so that it severely tested the credibility of the central bank. Chairman Jerome Powell seems to agree that providing estimates of where the Fed sees interest rates, economic growth and inflation at different times in the future should be dropped. “We think it’s time to just go meeting by meeting and not provide the kind of clear guidance that we provided,” he said after the U.S. Fed’s monetary policy meeting. July 26 and 27.

When it began providing forward guidance nearly 14 years ago, the Fed hoped that by clarifying its intentions through its quarterly summary of economic projections and press conferences, it could avoid market shocks. disruptive and reduce volatility. The 2008 financial crisis revealed the opacity of the old system and the need for transparency. The central bank succumbed to transparency pressures, and in December 2008 began using forward guidance when it cut its key overnight federal funds rate to near zero and said it “will use all the tools available to promote the resumption of sustainable economic growth and to preserve price stability. [Federal Open Market] The committee predicts that weak economic conditions will likely justify exceptionally low levels of the federal funds rate for some time.

The basic problem with forward guidance is that it relies on data that the Fed had a miserable track record of forecasting. He was always too optimistic about an economic recovery from the Great Recession of 2007-2009. In September 2014, policymakers predicted real gross domestic product growth of 3.40% in 2015, but were forced to consistently lower their expectations to 2.10% by September 2015.

The federal funds rate is not a market-determined interest rate, but is set and controlled by the Fed, and no one challenges the central bank. Yet the FOMC members were infamously bad at predicting what they themselves would do, as seen in the so-called dot plot of individual FOMC member rate projections shown in the chart. In 2015, their average projection for the federal funds rate in 2016 was 0.90% and 3.30% in 2019. The actual numbers were 0.38% and 2.38%.

Not only was forward guidance a failure, but it may have increased, not reduced, financial market volatility. The Fed raised rates in February 1994 without warning and within six months doubled the federal funds rate from 3% to 6% in November. This disrupted markets and sent US Treasury yields skyrocketing in what became known as “The Great Bond Massacre of 1994”. The yield on the 10-year Treasury bond jumped an unprecedented 2.3 percentage points from February to November this year. The Chicago Board Options Exchange Volatility Index, or VIX, which tracks the stock market, rose from 10.8 to 23.9 in April.

Despite the Fed’s credit crunch without warning, financial market volatility in 1994 was moderate relative to recent experience. Measured by taking the 20-day moving average of the daily percentage change in returns, whether positive or negative, the average volatility of 10-year Treasury bills in 1994 was 0.12%. The average volatility of the S&P 500 index was minus 0.01% and the VIX index for 1994 averaged 13.9.

Granted, many current events have caused uncertainty in the markets, but the Fed has been hot and heavy in this with its forward guidance. Recall that at the beginning of this year, the central bank believed that the inflation caused by the frictions during the reopening of the economy after the pandemic and the disruptions in the supply chain were temporary. Only belatedly did it reverse gear, raise rates and signal that more substantial hikes are to come. Misguided Fed forecasts led to misguided forecasts and increased financial market volatility.

Consequently, market volatility is much greater than in 1994, before the central bank published its plans. Using my same measure of volatility, this year to date it has averaged 0.46% for the 10-year Treasury. The volatility of the S&P 500 is also a higher number, negative 0.09%, and the VIX has averaged 25.8.

Thus, financial markets without forward guidance could be calmer. As Fed Chairman, Powell carries enormous weight at the central bank and I think his suggestion to end forward guidance will prevail.

• Powell will face a tough crowd in Jackson Hole: Bill Dudley

• This economy is proving too difficult for economists: Jared Dillian

• “Godfather” Insight into Market Drivers: John Authers

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Gary Shilling is president of A. Gary Shilling & Co., a consulting firm. He is the author, most recently, of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation”, and he may have an interest in the areas he writes about.

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