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.