The Newly Hawkish Fed’s Communication Problem

From time to time, Mark Thoma features the views of his University of Oregon colleague and Fedwatcher Tim Duy. Duy got his last call wrong. He genuinely believed the Fed would not cut, basically because not cutting was the right thing to do, and misread the FOMC’s sensitivity to market reactions, or to be less polite about it, lack of backbone. Duy has more recently focused on the Fed’s new hawkishness and the market’s refusal to listen (and perhaps deliberate bullying).

Duy says he spent the better part of the Thanksgiving holiday weekend trying to reconcile the central bank’s recent statements and forecasts. If I did a Vulcan mind meld with the Fed, I’d need a lobotomy afterward. Tim is clearly made of sterner stuff; his sanity seems intact, but he exhibits another side effect of too much engagement with an alien thought process, namely, having his mental functions unduly aligned with theirs. For example, before the last FOMC meeting, the reason Duy had persuaded himself that the Fed would hold firm was that the consequences for the dollar and ultimately the global financial system were too grim. Those concerns are absent from this post.

Duy comes to what pretty much everyone thinks will be the Fed’s December move, namely to cut again, but he sees this as being a closer call, However, he find in the Fed minutes the magic key that unlocks this issue:

To be sure, the Fed could simply ignore market participants and surprise with a pause, but if financial markets keep deteriorating over the next two weeks, I don’t think they will risk a surprise. From the minutes:

Participants generally viewed financial markets as still fragile and were concerned that an adverse shock—such as a sharp deterioration in credit quality or disclosure of unusually large and unanticipated losses—could further dent investor confidence and significantly increase the downside risks to the economy.

While the Fed would never say they were driven by market expectations, they also know that failing to meet the expectation of a rate cut is the same thing as an “adverse shock.” There is a time and a place for a credibility building negative shock, but I doubt the Fed believes that that time is now. That is the risk management side of policy.

But the interesting question is: is the Fed’s communication failure compounding its credibility problem? I vote yes. The very fact that we have to have Fed watchers says they are not conveying their messages effectively. The Fed is so used to relying on anodyne language that it seems unable to tell the financial community that it is just plain wrong.

Now in my version of Fed speak, a Fed president poses in front of the most enormous bank vault with Fed seals in view, and his chat, based on what Duy said is the Fed’s thinking, goes something like this:

We have told you in several statements in the last few weeks that we view the economic risks as balanced. That means we don’t see a rate cut as warranted until things change. Nevertheless, Fed fund futures prices have indicated for some time that the financial community thinks the odds of a rate cut in December is over 85%.

To put this in lay terms, “What about ‘no’ don’t you understand?” We have told you pretty clearly that we aren’t predisposed to lower rates. We strongly suggest you arrange your affairs accordingly.

Now we recognize that we may have a difference of opinion on the fundamental outlook. We’ve used the phrase “rough patch” to say we know things will almost certainly get worse before they get better, but we don’t see a meltdown in the offing. Yes, 2008 will be a lousy bonus and commission year. Yes, banks and investment banks will take big writeoffs and some players will fail. But that is not the end of the world, this is the normal operation of capitalism.

If anything, the bar for failure appears may be set too high. As you have seen in the last few days, even serial near-bankrupts like Citigroup that are too big to fail manage to get outside investors and muddle through. In fact, there are some near bankrupts like Countrywide that some of us wouldn’t miss at all, but we suspect they will muddle through too.

The problem is that there are quite a few people in a decision-making positions on Wall Street who have never seen a bear market. They all look terrifying for a few quarters, all the firms panic and fire too many people, but this passes.

The other part of our disagreement is about inflation. We noted that a fair number of people working in the financial services industry have never lived through a bear market. Even fewer have experienced inflation. Central bankers have been so successful at keeping it at bay, at least until recently, that the public isn’t as fearful of it as it ought to be. Inflation is corrosive; it makes investment unattractive, which hurts growth. It depresses both stock and bond prices and historically reduced new issues and trading volumes. And as Paul Volcker demonstrated in the early 1980s, it is painful and costly to subdue. If more of you had direct experience of it, you would be more willing to take some short-term pain to forestall it.

The world has moved to communication by sound bite. The Fed is the most listened to and least heard power player in the English-speaking world. and that is due to its failure to adapt its presentation style. Bernanke needs to work not just on transparency, but on communication strategy. Much of the content in their carefully wrought speeches gets lost because they are so worried about nuance that the main points get lost in the media recounting.

Although it is a long and detailed document rather than a speech, contrast the Bank of England’s semiannual Stability Report (latest edition here) with Fed publications. It conveys a tremendous amount of information and analysis, but the document is clear, lively, and quite accessible given its subject matter.

Back to Duy’s conclusion:

The conflict between the long term outlook and the short term risks leaves this once again a close call. Although the Fed would be happy to pause, recent deterioration in financials markets, including a flight to quality that threatens to push the 10 year rate below 4%, will make it difficult for the Fed to follow through on their hawkish rhetoric. But there is a point to the rhetoric – to keep us focused on the future, which the Fed can affect, not the present, which is already written in stone. The Fed will leap at the first opportunity to pause. For December to be that opportunity, markets need to stabilize and data need to conform to the Fed forecast.

Print Friendly, PDF & Email


  1. Anonymous

    Duy has been highly critical and even sarcastic about the Fed’s risk management approach. That’s unfortunate, since risk management is sensitive to changes in facts – a particularly important consideration in this type of fast changing environment.

  2. a

    The long bond is almost less than 4% so why would we need a rate cut to stimulate the economy?

    A rate cut isn’t about the economy; it’s about who on the Titanic gets a seat on the lifeboat. Cutting rates = GS and friends get the front row seats.

  3. Anonymous


    Is the dense verbage of the Fed not CYA language? It seems to me that the Fed is most worried about being wrong and getting the blame for bad moves. If the public cannot understand the Fed’s motives they cannot assign blame.

    If my salary and reputation depended upon the performance of the economy over which I had little real control, I’d speak as much nonsense as the public let me get away with (witness Greenspan). Only a true crisis of confidence in central banking would produce a central banker who would relate to the pubic in understandable ideas. We’re not there (yet?).


  4. Peter Pan

    I suspect the Fed will hold tight to test the market waters.

    If the market tanks then the Fed can make an emergency rate cut at the quarters ending options expiration the following week. Friday the 21st is just before a Christmas holiday weekend and market participation will be very thin that day. A rate cut could have maximum effect for that day.

    Peter Pan

  5. Yves Smith

    Anon of 9:12 AM,

    The Treasury prices have dropped considerably along the yield curve due to flight to quality. I don’t have the stats, but it is a virtual certainty that spreads have widened on the long end as they have on the short end.

    Even Paul Krugman, hardly the sort that sits in front of a Bloomberg terminal, has taken note. Here is a current version from David Merkel at Seeking Alpha:

    The FOMC can loosen interest rate policy, but how much will unsecured interbank lending rates like LIBOR respond? As it stands right now, the Treasury-Eurodollar spread [TED spread], is at 180 basis points, up from 96 basis points (or so — don’t have access to a Bloomberg Terminal). 17 basis points of that rise is a rise in LIBOR. That’s not the usual response that you expect to loosening monetary policy, but these are unusual times, when credit spreads dominate over monetary policy, even on high quality lending and short term.


    Agreed that is why the Fed communicates the way it does (look what happened to poor Mervyn King, the governor general of the Bank of England, when he very clearly said he believed in moral hazard and then along with the Treasury and FSA, bailed out Northern Rock? Much crow-eating ensued).

    The real problem is the Fed isn’t as independent as we like to think. I believe it was Willem Buiter who said the Fed was the one of the least independent central banks, second only to the Bank of Japan. If it was more secure in its position, it could be more straightforward.

    Nevertheless, the Fed’s failure to communicate to the markets points out the need for other strategies, or perhaps different “voices” for different messages.

    Peter Pan,

    That is a good strategy. Let’s hope that’s what the Fed does. The folks who are lobbying for further cuts have not focused sufficiently on how destabilizing they would be for the dollar and commerce. You can’t plan when currencies are this volatile. And there is also the not-trivial risk of a run on the dollar.

  6. Anonymous

    Central bankers shouldn’t be sleeping soundly.

    Last week’s financial market rioting sent a strong message to the Fed and other central banks that policymakers cannot wait to see spillover effects of tighter credit conditions on the economy. Quality spreads have soared and bid/ask spreads have blown out around the world. In Europe, it is alarming that interbank dealing in covered bonds came to a halt last week and planned high-quality debt issuance was cancelled. Measures of banking sector risk have exploded and liquidity in interbank money markets is deteriorating again. Interbank lending is the main channel through which central banks affect financial markets and the economy. Policymakers cannot allow these markets to stay moribund for long because it might mean that interest rate cuts become impotent. Bottom line: The Fed needs to cut interest rates promptly, and pressure is building on other central banks to follow suit.

    For what it’s worth.

Comments are closed.