Friday, March 25, 2016

What type of central bank is the Fed?

One of the confusions with monetary policy is determining the intentions of the central bank. With some many talking heads form the Fed, it is hard to determine what is the message that is being conveyed. In more formal terms, investors need to know the Fed's reaction function or how it will respond to different economic scenarios. If there is not a well-defined reaction function, there will be confusion.

At one extreme would be a central bank that is completely rules-based. There will be no room to maneuver and the reaction function would be clear for everyone. There would not be any need for speeches. At the other extreme would be a Fed that does not communicate any intentions or communicates regularly but in a inconsistent manner. A variation on this theme would be a Fed that does to have creditability. 

One of the current keys to central bank communication has been the idea of "forward guidance" or the use of communication to provide the market with its intentions in order to change expectations. Nevertheless, communication without a clear reaction function will lead to market confusion.

We believe that there are a number of descriptions for who the Fed is trying to be. These are sometimes in the form a metaphor for their behavior. Unfortunately, the description of the Fed at different times may be in conflict. Hence, it is not clear what their behavior will be at any particular time when there are multiple descriptors.

There is the lender of last resort as a fundamental Fed type. It represents reactive behavior that tries to provide liquidity at the right time. At the extreme, it could be a Greenspan or Bernanke put that has the Fed always providing liquidity when there is some market fall-out. The opposite is the Ulysses/Punch Bowl Fed that tries to take away liquidity before the "party gets started". There is also the "Keynesian Man" Fed as engineer who tries to adjust policy to meet its dual mandate of price stability and economic growth. The "inflation fighter" Fed is one dimensional but has often been viewed as the key role of the Fed. The Post Financial Crisis "watchman" Fed places more weight on the regulatory role and its efforts to dampen systemic risk. This is a new and evolving role. The "data dependent" Fed is a current focus which says the Fed is focused on key variables as opposed to a specific time-dependency on action. There is finally the "market guider" Fed that reacts to market and global events to as a prudent manager.

If you have one Fed model to describe its behavior, you will be confused if the Fed is behaving differently. The Fed may not always tell you its behavior so there is risk of not knowing the current personality. We current Fed personality can best be described as evolving. 

No comments: