After the financial meltdown of 2008, the lack of transparency within the financial system became clear. Since then, huge efforts have been made by Washington and critics to restore trust.
The Federal Reserve is not immune to the transparency bug. In late 2008, it began to use forward guidance — advance indications to households, businesses and investors of the monetary policy expected to prevail in the future. By providing information about likely changes before they occur, the Fed hoped to prevent surprise changes in policy that might disrupt markets.
I’ve long been skeptical of the effectiveness of forward guidance because future monetary policy changes are heavily dependent on data that are not yet known. Even worse, the Fed has been consistently too optimistic in forecasting these data since the recession began in 2007.
Consider the Fed’s June 14 decision to raise the federal funds rate, which was accompanied by the usual bearish adjustments to chronically optimistic inflation and economic forecasts. Now the central bank sees the personal consumption deflator, its favorite inflation measure, rising 1.6 percent this year, compared with a 1.9 percent forecast only three months ago. The PCE deflator has undershot the central bank’s 2 percent target for five consecutive years.
The Fed’s real gross domestic product forecasts have also been wide of the mark. In January 2011, it forecast 3.7 percent growth for 2011, 4 percent for 2012, and 4.2 percent for 2013. The results turned out to be 1.6 percent, 2.2 percent, and 1.5 percent, respectively. As shown in the chart, only six years later has the central bank cranked down its forecast close to the 2.1 percent annual average since the recovery started in mid-2009.
In line with these perennially high forecasts for inflation and economic growth, the Fed has consistently forecast quicker and more rises in the fed funds rate than occurred. Its new forecasts call for a 1.1 percent-1.6 percent range this year, down from the 1.4 percent-1.6 percent forecast in March.
The first implementation of forward guidance was in December 2008, when the Fed cut its short-term federal funds rate to near zero. In a statement, the Federal Open Market Committee stated it “will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”
Since this initial use, the Fed employed forward guidance as a policy tool throughout the remainder of the recession and the recovery, but adjusted its language regarding the rate-rise time frame as well as its forecast numbers. Later statements modified “for some time” to an “extended period,” then switched to specific calendar guidance that was pushed from “at least through mid-2013” to “mid-2014” and then to “mid-2015.” As weakness persisted, the Fed’s anticipated date for raising the short-term interest rate it controls receded.
In 2012, the use of specified dates was dropped, and the Fed instead stated that rates would remain zero bound at least until unemployment hit 6.5 percent. That threshold was later ditched, no doubt because the fall in the unemployment rate to the current 4.3 percent was mainly driven by people dropping out of the labor force, not by increasing employment.
To assess whether this monetary policy tool has been effective in preventing market disruptions, let’s compare conditions and volatility before forward guidance and after. Of course, there are vast differences between the conditions such as the economy, inflation and global growth now and those of the mid-1990s. Still, the differences in Treasury market volatility then and now are shocking.
The Fed raised interest rates in February 1994 without warning, and made six upward moves between then and November of that year, doubling its federal funds rate policy rate from 3 percent to 6 percent. This disrupted security markets and caused Treasury yields to skyrocket in what became known as “The Great Bond Massacre.”
Yields on 10-year Treasury notes jumped an unprecedented 2.3 percentage points from February 1994 to their November peak of 8.1 percent for a price loss of 23 percent, while the 30-year Treasury bond yield leaped by 1.9 percentage points for a principal decline of 17 percent.
Measured by taking the 20-day moving average of the daily percentage change in yield, regardless of positive or negative sign, however, the volatility in 10-year Treasuries in 1994 rose only from 0.6 percent at the beginning of the year to a peak of 1.1 percent in May, while 30-year bond volatility climbed from 0.5 percent to a top of 0.9 percent.
If forward guidance had its intended effect, you’d expect less stock and bond volatility recently — when it’s been vigorously applied — than in the mid-1990s before its advent. Nevertheless, the Fed’s use of the tool appears to be having the opposite of its intended effect of calming markets. Even before the first increase in the fed funds rate in December 2015, investors had become increasingly jittery over the prospect, so widely advertised by the Fed. The anticipation regarding potential rate hikes has spurred investor fears and increased market volatility to a level that vastly exceeds that of the mid-1990s, despite the rate increase of just 100 basis points so far compared with 300 basis points in 1994.
My index of Treasury volatility reached 1.9 percent for the 10-year in July 2016 and 3.2 percent for the 30-year this year — more than triple the volatility in 1994.
Looking at the volatility in yields before the advent of forward guidance and after, it does not appear that the signaling has been effective in preventing market disruptions, but rather has encouraged them.
Evidently, anticipation of Fed rate rises is a key factor causing volatility and uncertainty to plague markets. This is especially true with the Fed’s chronic over-optimism of economic growth and persistent crying of “Wolf!” about a strengthening economy and imminent numerous interest-rate hikes.
My advice to the Fed is this: If you can’t forecast accurately enough to make forward guidance useful, don’t try. The central bank had no mandate to forecast anything and didn’t present concrete numbers for most of its existence since its 1913 establishment. Before February 1995, the Fed didn’t even state its fed funds target.
So forget the Fed's forward guidance forecast numbers and verbiage and look instead at the cold reality. The U.S. economy continues to limp along at about 2 percent real annual GDP growth. Inflation remains negative in goods sectors due to globalization, and services inflation is fading in areas ranging from health care to education costs to financial services to retail sales as consumers retrench and e-commerce decimates in-store sales. Low as they are, U.S. Treasury yields exceed those of most other developed country sovereigns. All the forces suggest still-lower Treasury yields, and my targets remain 1 percent for the 10-year note versus 2.1 percent today, and 2 percent for the 30-year bond compared with the present 2.8 percent.
The Fed says it will raise rates again this year and reduce its assets, but I’m skeptical and so are markets. When the central bank hiked the fed funds rate 25 basis points on June 14, the 30-year Treasury bond price jumped almost three points as its yield fell.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.”