The future of forward guidance
The Fed has been usually specific this year about its plans, signaling the likely size of interest rate hikes ahead of time. Last week Chair Powell said that's over, for now.
Today’s post was initially for paid subscribers on Chair Powell’s comments on forward guidance at the July press conference and some of the tool's early history. Now it’s ungated.
Source: Getty Images
Words are powerful, sometimes too powerful. So, the Fed is saying less for now.
Forward guidance is when the Fed publicly says the likely future path of the federal funds rate or other tools like the balance sheet. Those words move financial markets, sometimes more than the official vote. The Fed’s goal is to influence longer-term interest rates—the typical borrowing costs of families and businesses—by affecting a series of short-term interest rates. (The federal funds rate is a short-term rate.)
Recently, the Fed has used unusually explicit guidance to reduce uncertainty about its intentions to raise rates rapidly. The idea was, in part, to make up for delaying liftoff. When markets believe the Fed’s guidance, it amplifies the effects of the rate hikes that have already occurred. When they don’t, it’s just ‘cheap talk.’
A recent example of guidance was at the May press conference. After the Fed raised the federal funds rates by 50 basis points, Chair Powell said:
You can see— unanimous vote today, of course. And I told you the guidance—that broad support to have 50-basis-point hikes on the table at the next couple of meetings.
That is as clear as Fedspeak gets. Typically, forward guidance is tied to data and, consequently, is fuzzier. The financial markets listened to that guidance in May. Sadly, inflation did not. In the end, worse-than-expected inflation data led the Fed to raise by 75 basis points in June. And again in July.
We learned this last week, almost certainly related to the fiasco in June, that the Fed is hitting pause on such explicit guidance. Here’s Chair Powell at the July press conference after the Fed raised rates by 75 basis points again:
… as it relates to September, I said that another unusually large increase could be appropriate, but that's not a decision we're making now. It's one that we'll make based on the data we see. And we're going to be making decisions meeting by meeting. We think it's time to just go to a meeting by meeting basis and not provide the kind of clear guidance that we had provided …
Below the paywall, I unpack that and other statements from him at the press conference, suggesting a shift but not an end of forward guidance. And, of course, the dot plot (from the Summary of Economic Projections) is still in the mix. Finally, I share research and a podcast on the evolution of forward guidance since the 1950s.
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The June meeting is a stark example of how forward guidance can create tension between being credible on guidance and being data-driven. That time the data won, likely at some cost to credibility. There are past examples where it went the other way.
Letting go of explicit guidance doesn’t cost the Fed much
At least not now.
Forward guidance is always risky, even more so with an economy that is haywire. We don’t know where we are now: Recession? No recession? Sundry other puzzles? It is impossible to forecast where we are going, even six or eight weeks ahead. The latest CPI print is in the driver’s seat now. And there is no reason for the Fed to pretend to know what it will do and thus no reason to tie its hands with guidance. And no reason to pretend that markets will believe the Fed if it did give guidance. It’s not so much a credibility problem; it’s a world-is-haywire problem.
And that’s shown in bond markets recently, which—contrary to the Fed’s expectations—expect a rate cut next year. The markets know that as the data change, the Fed will change, and there are scenarios next year where the data would warrant a cut. Though it does not seem every Fed official sees it that way:
One answer to Neel’s confusion is that markets are increasing, convinced we will be in a recession by the start of the year. I am too. Throw in some financial market distress, and you get a Powell Pivot, though a rise in the unemployment rate on its own will not cause it.
So, for now, the Fed is mostly sticking with its fuzzier terms like “expeditiously” or “nimble” or “unconditionally” or “compelling.” The Fed is standing on firmer ground with these types of terms. They are fuzzy enough to allow latitude in the decisions and still descriptive enough to give a general impression of the Fed’s plans.
The downside of being vague is being misunderstood. Fedspeak is an art form; most people treat it like a Rorschach test and hear what they want to hear. The Fed doesn’t like to lose control of the narrative, but that’s hard to do if you refuse to tell the narrative.
The Fed didn’t stop on numeric guidance
The Fed understands that trade-off and has another tool that gives numeric guidance, albeit with considerable wiggle room: the Summary of Economic Projections, which includes the so-called dot plots. The dots are the “appropriate” path for the federal funds rate this year and the next two for each FOMC participant. Here is the latest from June that the Fed will update at the September meeting.
Technically, these are data-dependent, since they are “appropriate” within the context of the participant’s expectations about the economy. That is a very subtle, often missed point. The SEP is complex. And even the Fed doesn’t emphasize that much. Nonetheless, it’s getting the spotlight.
Powell pointed to the SEP several times at the July presser:
We've been front-end loading these very large rate increases, and now we're getting closer to where we need to be. So that's how we're thinking about it. In terms of September, we're going to watch the data and the evolving outlook very carefully. And factor in everything and make a decision in September about what to do. I'm not really going to provide any specific guidance about what that might be. But I mentioned that we might do another unusually large rate increase, but that's not a decision that we've made at all. So we're going to be guided by the data. And I think you can still think of the destination as broadly in line with the June SEP. Because it's only six weeks old. And sometimes SEPs can get old really quick. I think this one I would say is probably the best guide we have as to where the Committee thinks it needs to get at the end of the year and then into next year.
But at the same time, I would say that's probably the best estimate of where the Committee's thinking is still. Which is that we would get to a moderately restrictive level by the end of this year, by which I mean summer between 3 and 3 and a half percent, and that when the Committee sees further rate increases in 2023.
Keep in mind there are only three meetings left this year: September, November, and December. So that "by the end of the year” guidance will soon undermine “meeting by meeting” only guidance. It is already close to 75 to 100 basis points in total over three more meetings. I have long-standing concerns with the Summary of Economic Projections, and I worry that it will get hard to handle soon. It’s more common for a Fed Chair to talk down the SEP than repeatedly talk it up to make his case. It is puzzling the same day, he announced going “meeting to meeting.” This move is like the Fed trying to have its cake and eat it too.
But the Fed got burned by the June guidance. Meeting-ahead, unconditional guidance does not allow the Fed to be as “nimble” as they need to be. They want to keep signaling to markets that they are tough on inflation and have more tightening coming. They are willing to risk losing some clarity to reclaim flexibility. They are playing a bit with fire with the SEP, but that’s a game they know.
Forward guidance is a tool that's evolved over time
The general impression is that forward guidance is a new idea born out of the Great Recession when the federal funds rate was at the Effective Lower Bound. Indeed, it’s then that guidance became a formal tool, but there’s a long history of the Fed weighing the power of its words in financial markets.
Research by Ed Nelson, a senior Fed staffer at the Fed covers the evolution of the Fed from a tight-lipped institution to one signaling the rate increase at the next meeting:
They concentrated on describing future policy in terms of achievement of economic objectives, with their commentary on interest-rate prospects usually confined to consideration of the longer-term factors affecting rates. Even in these years, however, there were infrequent occasions—notably in 1974 and 1982—when policymakers provided more explicit guidance regarding the path of short-term rates. In the 1990s, a consensus developed in U.S. policy circles that was more receptive toward the notion of guiding longer-term interest rates by providing indications of future FOMC actions. This consensus developed even before concerns about the lower bound on short-term rates became prevalent in U.S. policymaking. The new mindset, which stressed the stabilizing effects on the economy of communication of policy intentions, set the stage for the emergence of forward guidance as a monetary policy tool.
The main reason that guidance was not fully adopted sooner was concerns about the Fed being constrained in its future decisions that outweighed the benefits of affecting longer-run interest rates. Note, it’s the same tradeoff that the Fed faces today and explains why explicit forward guidance is limited to extraordinary situations.
The shift in the Fed’s thinking toward guidance began in the 1990s. It was due to more economic theory in favor of it; the emergence of inflation targeting, which is forward-looking; and greater comfort with the Fed’s reaction function. Instead of expressing exact numbers, the Fed slowly explained how its intentions were tied to incoming macroeconomic data. That form of guidance remains the more prevalent, but over time forward guidance has developed into a formal tool.
I will leave you with an excellent conversation between Ellen Meade, a former senior staff at the Fed and academic, and David Beckworth. It’s a wide-ranging tour of Fed policymaking and its evolution from the perspective of someone there for several decades. Toward the end, Meade discusses forward guidance and increasing transparency at the Fed. The push often came from Congress, even if the theory came from economics.
Wrapping Up
The Fed has increasingly used forward guidance to amplify the effects of the federal funds rate on the long-term interest rates. Within the first five months of this tightening cycling, we have seen both the benefits and the costs of explicit guidance. Don’t expect such specificity again any time. Prior guidance last year and during the past ten years tied to economic conditions also has had mixed outcomes. “Compelling evidence” of inflation moving to 2% is in the spirit. We are likely to see that firm up more. Until then, we have the dot plot, such as it is. And the tsunami of Fed officials' public statements. Words are powerful, but not always. The Fed can say all that it wants. Forecasting the Fed now is forecasting inflation.