The risk of a collision between the Federal Reserve and the markets

The risk of a collision between the Federal Reserve and the markets grew on Friday after Fed governor Randall Kroszner made it clear he believed that the US central bank was not planning to cut interest rates at its next policy meeting, but was largely ignored by investors.He said: “The downside risks to growth now appear to be roughly balanced by the upside risks to inflation.” Data and information received since the Fed’s October meeting “have not changed my thinking in this regard”, he added.

“The market” has apparently blithely ignored all such signals:

… the federal funds futures market on Friday priced in a more-than 80 per cent probability that the Fed would cut rates in December, while the yield on two-year Treasuries fell.

Why? Well, first, there is the game of bluff: are we supposed to be assuming that the federal funds futures market is entirely unbiased? I wouldn’t think so (but, then, I’m cynical like that). Previous research, however, has already demonstrated poor performance, including bias, in the futures market:

The federal funds futures market naturally embodies the market’s expectation of future Fed policy. However, the federal funds futures rate is a forecast of the average monthly level of the funds rate. The potential for bias and the fact that the federal funds futures rate forecasts the funds rate and not the funds rate target means that using it for forecasting Fed action is considerably more difficult than it might at first appear.

The paper, from 1997 (somebody ought to update the analysis, now that I think of it), found the following performance:

Table 1

Table 2

Overall, the accuracy was around 70% – but that was made up of correctly predicting change in the rates and no change in the rates. Guess which is the easier prediction? The market called a change only 30% of the time.

Why?

One potential source of this bias is the effect of settlement Wednesdays. The funds rate deviates substantially from the targeted level on the final day of the reserve maintenance period, called settlement Wednesday. It is unusually high if reserves are scarce or unusually low if reserves are abundant. If, on average, reserves were a little scarce on reserve settlement days, the monthly funds rate could average a few basis points higher than the target.

It is also possible that the behavior of this series has changed over time, partly in response to the Fed’s disclosure policy. Evidence (Thornton, 1996) indicates that, prior to the Fed’s policy of immediate disclosure, the market took a few days to figure out that the Fed had changed its funds rate target. If so, the funds rate would trade above the target when the Fed reduced the target and below it when the target was raised. During the period prior to immediate disclosure, the Fed changed its funds rate target 27 times. Of these, 22 were decreases, and only 5 were increases. Hence, it would not be surprising to see a positive bias in the funds rate over the funds rate target for this period, but the bias should disappear with immediate disclosure.

Formerly, the Federal Open Market Committee (FOMC) announced its policy decisions about six weeks after the previous meeting. At its February 1994 meeting, the FOMC broke this long-standing tradition and announced the decision as soon as it was made. While the FOMC made no commitment to continue the practice, the next five changes (all increases) were announced immediately. The new policy was formalized at the February 1995 meeting.

Hence the update. I would like to see whether this phenomenon has settled, at all. The authors of this paper did find, however, that the bias could be corrected, and more accurate predictions can be found by adjusting the known-to-be-off gambles observed in the futures market:

Table 3

That’s still barely more than 50% of instances in which a change was predicted, that a change subsequently occurred. So…

Getting back to the story itself, though. The Fed is in the position many people were painting back after their first rate cut – little apparent credibility.

Peter Hooper, chief economist at Deutsche Bank securities, said he was “troubled” by the gap between what Fed officials were saying and what the market was pricing.

Vincent Reinhart, a former chief monetary economist at the Fed, said the central bank was clearly stating that it “views the risks as balanced and is reluctant to ease further”.

Andrew Balls, central bank strategist at Pimco, said market participants appeared more focused than Fed policymakers on problems in the financial sector that could lead to tighter credit conditions.

Larry Meyer, a former Fed governor, said the central bank “has put itself in a box to some degree.” He said credit markets had clearly deteriorated since the last Fed meeting.

It seems that, to some extent, officials are going in for verbal intervention, rather than actual:

… Hank Paulson, US Treasury secretary, kept up his increasingly vocal advocacy of the “strong dollar policy” in an apparent bid to reassure global investors that the US was not indifferent to the fate of its currency.

The Treasury secretary told reporters in South Africa that he “very much” supported a strong dollar and believed that the ­“fundamental, long-term strengths” of the US economy “will be reflected in currency markets”.

The dollar, which has shown some tentative signs of stabilisation this week, rose against the yen but fell against the euro and sterling.

Every time, one would think. Ross Gittins wrote an excellent piece, recently, explaining that/how modern Treasurers have little actual control over economies, these days: their job is to talk it up, when needed. The trouble with this administration’s bluffs, however, is that it’s been all bluff, almost the entire time.

It just doesn’t have the credibility now. Bernanke’s Fed has talked no-change only to cut rates, Paulson talks strong-dollar while no aspect of macro policy is directed at bolstering the dollar: In the macroeconomic equilibrium model

Aggregate Demand = Consumption + Investment + Government Expenditure + Net Exports

it clearly expects a low dollar to boost Net Exports, and it seems to be relying on that boost in Net Exports to buffer the US economy against recession for as long as it can (and hopefully that will be long enough).

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