Yesterday’s FOMC saw the first tapering of bond purchases by the Fed, by $10 billion per month. To soothe markets, the Fed also reinforced its forward guidance, making it “stronger and longer”, by a promise to leave the Federal Funds rate close to the zero bound “well past the time that the unemployment rate declines below 6.5%”.
Influencing a soon-to-be Yellen-led Fed are concepts like “secular stagnation”. This claims that that the economy is suffering from an epochal downshift in growth and requires very loose monetary policy for an extended period to try to mitigate the damaging effects of such stagnation. Forward guidance ties into the “optimal control theory” favoured by Yellen – a policy that prescribes an ex ante preset path of rates that is adhered to, regardless of whether on shorter time frames actions may seem sub-optimal – to try to remedy secular stagnation.
As the Fed moves away from QE towards a greater reliance on forward guidance, this will store up more problems, in our view. QE involves actions, but forward guidance is just talk, and talk is cheap. Central bankers may have been encouraged by Draghi’s “whatever it takes” speech to save the euro last summer, but our contention has always been that costless commitments create an unstable equilibrium, and eventually the market will ‘call’ the ECB on this promise.
At some point action will needed to back up words, and it is at this point verbal commitments will unravel. Furthermore, forward guidance requires clarity and simplicity.
Yet, with terms such as “triggers”, “thresholds”, “knockouts”, etc, being flung around, as well goalposts being moved with various targets changed, the risk is of market confusion, or doubt. This will ultimately require firm action to dispel.
Unfortunately it is then we may see volatility – artificially repressed by costless gestures – lurch higher, an outcome corroborated by our own VP Leading Indicator for equity volatility. This leading indicator is structural in nature and maps future volatility as a function of corporate leverage, credit spreads and other variables. Volatility may certainly continue to stay depressed in the near term, but the risks are now tilted to the downside.