The Federal Reserve’s forward-looking program has turned out to be a disaster, so much so that it has tested the central bank’s credibility. Its chairman, Jerome Powell, seems to agree that providing estimates of where the Fed expects interest rates, economic growth and inflation to be at different points in the future should be ruled out.
“We think it’s time to go meeting by meeting, so that we stop providing the kind of more or less clear guidance that we have provided”, he said after the monetary policy meeting of the fed July 26 and 27.
Nearly 14 years ago, when it began providing forward-looking guidance, the Fed hoped that by making its intentions clear through its Quarterly Summary of Economic Projections and press conferences, it could avoid market disruption and reduce volatility. The financial collapse of 2008 revealed the opacity of the old system and the need for transparency.
The central bank succumbed to transparency pressures and in December 2008 began using forward guidance when it lowered its overnight fed funds policy rate to near zero and said that “will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Federal Open Market Committee (FOMC) anticipates that weak economic conditions are likely to justify exceptionally low levels of the fed funds rate for some time.”.
The basic problem with forward guidance is that it relies on data for which the Federal Reserve has a poor forecasting record. After the Great Recession of 2007-2009, the fed was consistently overly optimistic about an economic recovery. In September 2014, monetary policymakers forecast real gross domestic product growth in 2015 at 3.40%, but were forced to steadily lower their expectations to 2.10% in September 2015.
The fed funds rate is not a market-determined interest rate, but is set and controlled by the Federal Reserve, and no one challenges the central bank. However, the forecasts of the members of the FOMC they were terrible at forecasting what they themselves would do, as seen in the so-called dot plot of individual FOMC members’ rate projections shown on the chart. In 2015, the average projection for the 2016 fed funds rate was 0.90% and 3.30% in 2019. The actual figures were 0.38% and 2.38%.
Forward guidance has not only been a failure, it may have increased, not reduced, financial market volatility. In February 1994, the Fed raised rates without warning and within six months doubled the fed funds rate from 3% to 6% in November. That upset markets and caused US Treasury yields to soar in what became known as “The Great Bond Massacre of 1994″.
From February to November of this year, the yield on the 10-year Treasury note rose an unprecedented 2.3 percentage points. The Chicago Board of Options Exchange Volatility Index, or VIX, which tracks the stock market, soared from 10.8 to 23.9 in April.
Despite the credit crunch of the fed Without warning, volatility in financial markets in 1994 was moderate compared to recent experience. The average volatility of 10-year Treasury bills in 1994 was 0.12%, measured by taking the 20-day moving average of the daily percentage change in yields, whether positive or negative. The average volatility of the S&P 500 index was negative 0.01% and the VIX index for 1994 averaged 13.9.
Undoubtedly, many current events have caused uncertainty in the markets, but the fed he has been there very strongly with his future orientation. He recalls that earlier this year, the central bank believed that inflation caused by frictions in the post-pandemic economic reopening and supply chain disruptions was temporary.
Alone, and belatedly, he changed his mind, raised rates and signaled more substantial increases are on the way. Faulty Fed forecasts resulted in faulty forward guidance and increased financial market volatility.
Consequently, the volatility in the markets is much higher than in 1994, before the central bank released its plans. Using my same measure of volatility, this year to date has averaged 0.46% for the 10-year Treasury note. The volatility of the S&P 500 is also higher, negative 0.09%, and the VIX has averaged 25.8.
Therefore, financial markets without forward guidance can be calmer. As Fed chairman, Powell wields tremendous weight at the central bank, so I think his suggestion to end forward guidance will prevail.