Thursday, March 17, 2016

Time-dependent vs data-dependent Fed forward guidance

I did not have a good way of expressing how the Fed should convey information after the lift-off until I read the recent paper, "Language after Lift-off: Fed Communication Away from the Zero Lower Bound" by a group of Wall Street and academic economists with a lot of Fed experience. The current policy confusion about communication is caused by the Fed and the market focusing on "time-dependent" messaging when it should be "data-dependent".This paper is a long but worth the effort. Most can read it quickly, but it is filled with little nuggets of important information. 

One of the key monetary policy issues is the form of forward guidance by central bankers. This issue has become all the more important in the zero lower bound period especially when Fed wanted to sent signals on the path for rising rates. There has been too much focus on "time-based" forward guidance. When will rates start to rise and when will be the next move by the Fed? Will it be this FOMC meeting, or the next one? This focus on calendar time has been to the detriment of the more important issue of data-dependence through the macroeconomic information. 

Data dependency is not the same as time dependency. Data dependency is still the driver of policy and not same time path. The confusion is not knowing the Fed's reaction function. It has not be well described. In the pre-crisis period, the Taylor Rule was a good working tool for policy reaction, but something different is needed in the current world. 

Why has there been so much monetary policy confusion? An interesting piece of information presented is that there has been more words from the Fed since the Financial Crisis, but that has not meant that there has been more information. Forward guidance is important when rates are at the zero bound, but what is said or how it is said is critical.

Clearly the forward guidance took a very different tone in the post-financial crisis period. This was the period when the Fed asked about "extended periods". Currently, the language is more focused on data conditions, but there was key focus on time last fall. The move to clear data dependent guidance is critical to helping the markets understand Fed actions.

When the Fed becomes more time dependent, there is less sensitivity to macroeconomic data. During data dependent periods, the market will react more to any new information. If the Fed convinces the market that it is more data dependent, volatility around economic announcements will increase.

This policy framework discussion provides investors with some very useful information on the sensitivity of yields to data and the path of risk premiums in bonds. An adjustment in forward guidance focus will change how the markets look at FOMC announcements and discount Fed comments.

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