FOMC – When Forward Guidance becomes a pre-commitment
17th October 2016
A guest article by
Tor Vollaløkken
Central bankers are generally not too happy about sticking their heads out and talking about what the future will bring. They are economists used to study facts and figures, and while their jobs are very much about making assumptions and forecasting several elements about how the future will look like in terms of economics, they are not used to telling markets and the public what their findings are.
Forward guidance has become part of their job – to reduce the surprise element to markets in what their monetary policies will be and to explain to the public what they are doing and why. To set out their thoughts in statements, projections, press conferences and minutes from their meetings is rather new to most of them and one can easily see that they are not used to – or at least have not found a way to do this without saying too much or too little.
The best sample is the Federal Reserve System where forward guidance since the period the bank introduced tapering of their asset purchase programs, has illustrated a big discrepancy between what FOMC members have advocated as their USD interest rate outlook and that of markets.
Generally – the FOMC members and most of its members have argued and predicted a higher level for USD interest rates throughout 2015 and 2016 than what markets have priced in. Throughout most of 2015, Fed officials gave us reasons to believe the Fed Funds Rate could be increased as early as in their June meeting of last year. Then focused shifted to either of the Autumn meeting and in the end, we ended up with the first raise of the Fed Funds rate in their last meeting of the year – in December 2015. They often used US data as being the deciding factor for such a move, which by December of last year didn’t look like being a supportive argument. But having talked about a raise of the Fed Funds Rate for most of that year, it more looked like something they had to do by the time we got to their last meeting. My feeling was that this was something they had to do – almost like a commitment from their repeated forward guidance.
Having conducted one rate hike, the forward guidance from the first meeting of this year was one of seeing a 1% hike of the Fed Funds Rate this year and in the form of 4 increases. So far this year we have had none while we have had statements, press conferences and minutes indicating that the next one is likely just around the corner. Markets are sceptical – not only as expressed by analysts and commentators – but also through the pricing of USD interest rate products, which show a big discrepancy to those rather optimistic projections FOMC members expressed. For most of this year, the CME Fedwatch has predicted the next hike of the Fed Funds Rate to take place well into 2017 and at no time priced in the four increases Fed officials advocated.
With two FOMC meetings remaining for this year, we could in theory get two increases of the Fed Funds Rate but more likely only one. If so – it would be the only one out of the four Fed officials saw coming up not more than nine months ago.
While it is difficult to forecast interest rates, markets look to have had a better understanding of the strength of the US economy than what Fed officials have had. Forecasting the US economy is always difficult, so what I say is not to discredit the Fed in any way. There have been plenty of previous periods where they have been better than markets in terms of forecasting.
The problem is that the way they present their forward guidance and the continued delays there is between what they indicate and what they do, is “cornering them” in such a way that at one point they must make a move. I very much felt that this was the case back in December of last year and it looks to me as this will also be the case this year. We will get a hike of the Fed Funds Rate in November or December – not so much from the strength of the US economy but more from that the forward guidance given throughout this year has turned into a commitment to make on.
