Commentary: What We Have Here is a Failure to Communicate

Perhaps one of the greatest consequences of the 2008 financial crisis has been the profound shift in the manner in which monetary policy implemented.  With policy rates pushed to their zero bound, central banks around the global have turned to large scale asset purchases and signaling to guide economies along the path to recovery. The move towards relying on communication is not surprising, given that QE and other large interventions blunt the Fed's ability to respond quickly to short-term shifts in the money market.  Specifically, under normal conditions, when bank reserves are in the billions and not the trillions, small purchases or sales of securities (on the order of 100 million USD) by the central bank can have a great impact on the money market.  However today, such trades would be a proverbial drops in the bucket when stacked up against the 1.9 trillion dollars in excess banking reserves created by QE.  The Fed is thus forced to do its best to guide the money market via forward guidance and other subjective communicative techniques. Suffice to say, unlike simply trading a few hundred million treasury bonds one way or the other, the response by the market to such actions is hard to predict.  

Judging by the Fed's own guidance and communication over the past few months, it is unlikely that it intended rates to rise sharply.  Chairman Bernanke has stressed repeatedly that a reduction in asset purchases does not portend a tightening of monetary policy.  Rather, it represents a slowing of further easing; therefore, measures to raise interests remain a long way off.  As evidenced by the sharp rise in bond yields globally, and the near 40 basis point rise in mortgage rates last month, the broader market remains largely unconvinced.  What we are seeing play out in financial markets around the world is the simple truth that no analyst, stock picker, and certainly not the Federal Reserve Board can accurately predict the collective reaction of millions of investors, bank managers, and speculators to specific news or information.  The Fed was able to successfully calm markets via forward guidance when it rolling out is aggressive easing policies.  However, despite visible efforts, the Fed has not been able to communicate or even discuss the particulars of its exit strategy without making markets swoon.       

While the Fed's dramatic injection of liquidity into the financial system over the past four years has undoubtedly succeeded in stabilizing credit markets and jump starting the economy, it has left the Fed in the unenviable position of having to used subjective measures to transmit monetary policy.  The Fed has shown its tremendous capacity to tackle a crisis, but ironically, it has clipped its own wings in terms of its ability to influence small changes in credit conditions.  Alas, the high volatility of both stocks, bonds and currencies over the past few weeks makes us yearn for days when the Fed could manage rates by simply telling its trading desk to buy or sell a few hundred million dollars of treasury bonds.  Markets didn't whip saw every time a Fed official opened their mouth, and central banking was boring. But for now, what we have here is a failure to communicate.