A House in Order
Is Fed forward guidance about forecasts, or context?
BINYAMIN APPELBAUM. Binya Appelbaum, New York Times. Does “a couple” mean two?
CHAIR YELLEN. So “a couple” — I believe the dictionary probably says, “a couple” means two. So, “a couple” means two.
At the conclusion of Chair Yellen’s 17 December 2014 press conference, Binyamin Appelbaum (New York Times) tweeted a follow up to his first question.
His tweet is amusing, but also quite serious. In an age of guidance-filled central bank toolboxes, words are weighed and worried about.
What may seem like snark to the less initiated actually isn’t at all. Appelbaum probably did just save us three months of analyst notes about the meaning of “a couple.” Thus his tone invites us to wonder why that’s the case, and whether it should be the case as we head into an unprecedented phase of normalization. Are we worrying over words that much?
Perhaps. But there’s a reason for it.
It’s not that the Fed is obsessed with words. It’s that communications, in the form of forward guidance, has become a central component of the Fed’s toolbox.
A core part of effecting the normalization process, the return to interest rates following six plus years in the zero lower bound, will be determining just how the Fed will most optimally communicate its policy intentions to the markets, to sovereign states and to the greater public. It is an evolving process.
One choice we confront looks something like this:
Will communication give a forecast, i.e. what the Fed expects to do, or will it give a context, in the form of gradually establishing the framework for the Fed’s shift into its 21st century role, i.e. what the Fed is and does?
Will it draw a subtle line on a map, from A to B, leaving you to interpolate? Or will it describe the mode of transportation, and the scene around it, engaging you as a companion on a journey?
Currently, markets consider forward guidance in the former sense. Chair Yellen is associated with this style, as was former Chairman Bernanke.
“Tell them what you plan to do. Present a range of plausible forecasts so their behavior going forward will adjust accordingly,” at least in theory.
The second version, or guidance in the context sense, is the more intriguing of the two. It is the sort associated with current FOMC Vice Chair Stanley Fischer.
Is something wrong with forecasting?
While forecasts in themselves can be helpful, forecasts might be wrong. They can often tend too hopefully, and thereby overshoot reality.
Confronting forecast errors, it’s easy to say, “simply forecast more accurately,” or “forecast more conservatively.”
But within forward guidance, these aren’t real options.
The Fed MUST play it hopefully. As I described in a quick and informal post on Facebook back in October 2014, forward guidance is designed to build and mold forward expectations and the economic behaviors associated.
While guidance is a wide ranging communications tool, rather than a more specific lever affecting rates directly, guidance may shift economic behaviors with a higher degree of probability toward a desired range of outcomes.
This shift, if successful, can gently and manageably effect change in far less disruptive ways than blunt tool interest rate moves or related open market operations could. Forward guidance, played well, can enable desired outcomes to self-fulfill and allow the Fed to step back and do nothing. An expectation of better conditions may bring future purchases or investment plans into the current day. This may, in theory, bring velocity to the economy which results in hiring. The market will, upon proper nudging, theoretically opt to do its own work.
In reality, however, the Fed is limited to guidance within such ranges as the data will plausibly allow. In other words, the guidance can only be as positive as reasonable, legitimate current data supports. Yellen’s first year has seen a lot of work towards making labor market data more detailed, precise and meaningful to current structural, cyclical and technology-driven conditions. Yellen’s dashboard (visit the New York Fed’s interactive feature here) deconstructed old indicators which had become outdated and less relevant.
This redesign has been welcomed by market and academic audiences alike and as observed within the August 2014 gathering at Jackson Hole, Wyoming, is influencing other global central banks seeking to gain insight into their own shifting labor markets.
But even with the new and better tools Yellen has taken care to introduce, the issue remains: forecasting, however wonderful its methods, is subjective. It tells a tale which may or may not come true. Forward guidance involves finding the right thing to say to entice the economy to do the right (that is, optimal) thing. But the right thing to say and an accurate forecast are not always the same thing. Knowing that the latter (i.e. being an accurate oracle) is not a reliable plan, the former comes in as a next best choice.
And writers, some of them in possession of a PhD in economics and some of them still eagerly on their way to such things, are traipsed in to help leading economists throughout the Fed and greater SIFI tier find the right words to communicate a forecast-not-forecast.
Viewed in this frame, it’s easy to see Binya Appelbaum’s question about “a couple” and “two” as a friendly, supportive wink to Chair Yellen. Appelbaum shows understanding of the challenge that she faces in her role, and by extension the challenge he faces as one reporting it in The New York Times.
Appelbaum knows that he’s part of the process; he’s one of the channels by which forward guidance makes it out the door of the imposing Eccles building.
Others have the opportunity to be even more candid about the Fed’s foray into wordsmithing. Caroline Baum, in e21 is direct in her criticism of the Fed’s forecasting adventures, calling the incessant conversations (as revealed in the FOMC minutes) around word and phrase selection to be a waste of time. Yet she acknowledges,
One reason not to change the forward guidance may be the lack of an adequate substitute.
What might be the better alternative to what’s always going to tend to be an imperfect, and some would say meaningless, forecast? One which, as I referenced in a recent post, Here There Be Dragons, the market might choose to ignore anyway?
Baum has an inkling of who might have the answer. She makes a suggestion: Let’s watch Vice Chair Stanley Fischer.
Fischer joined the Fed as vice chairman in May (2014), and I’ve been waiting to see if he can sway his colleagues with his atypical — for a central banker, at least — views on forward guidance.
Baum calls out Fischer’s rather blatantly different view of the nature of guidance. In Here There Be Dragons, I discussed the Yellen mantras of transparency and non-surprise, both of which enable Yellen’s strategy of a forecast-driven forward guidance.
Are the two in opposition? Baum referenced a Wall Street Journal link in questioning how Fischer felt about the worthiness of forecasting. Via Tom Wright, Wall Street Journal, 23 September 2013:
Fed officials have placed great store on these communications. By assuring the public that it will keep short-term interest rates low for several years, for instance, the Fed is sending signals aimed at holding down long-term rates to boost growth.
But Mr. Fischer said making such statements — known as forward guidance — can cause market confusion.
‘You can’t expect the Fed to spell out what it’s going to do,’ Mr. Fischer said. ‘Why? Because it doesn’t know.’
He added: “We don’t know what we’ll be doing a year from now. It’s a mistake to try and get too precise.”
Mr. Fischer said he tried, on becoming governor of the Bank of Israel in 2005, to give signals to the market — but quickly gave up as he realized it restricted the bank’s future actions when circumstances changed.
‘If you give too much forward guidance you do take away flexibility,’ said Mr. Fischer.
Part of the problem around giving indications of future actions is they are conditional and nuanced.
Fischer’s comment on flexibility is notable, as one of the reasons for press conferences in the first place was to gain flexibility. Indications of future actions being conditional and nuanced represent an intended aspect of that flexibility, rather than a limit upon it.
The Fed Chair’s press appearances began in 2011, as an unconventional toolbox addition, post 2007–08 crisis-slash-panic. While Chairman Ben Bernanke was the first to appear, his Vice Chair, then Dr. Janet Yellen herself, had much to do with this historical moment.
The forward guidance toolbox, and the changes it has promptly brought to the perception of the Federal Reserve globally reflects much of her own design.
The rationale for this design, at a high level, was this:
The global economy was fragile and blunt tools like interest rate levers were situationally imprudent. Soft tools which interacted with support actions over and above political motives and sovereign states were a more ideal interim plan. Forward guidance, floating lithely and angelically above the borders of countries and oceans would soothe and direct the way back to what was to be called, in a future time, “normal.”
The Fed opened its mind and microphones to the media, and the media effectively became part of its “identity” arm.
The Bernanke-Yellen transition in early 2014 saw new focus into “the space between”— “translators,” for all purposes, between the research and last mile delivery functions to markets, political entities, and the public.
Such translators were also brought on by firms for whom Fed, market and media interaction are essential inputs to major cross-border investment deals and decisions.
Message coordination is a global multiparty effort regardless of one’s vantage, and that leads to a perhaps larger point: Guidance is less a component of domestic economic policy; it’s more about solving a global puzzle of 21st century organizational behavior. It’s a type of proactive strategic diplomacy. Communication is a way to enable stable, non-violent, less costly interaction across diverse entities without using overt rule or force.
Knowing this, Janet Yellen recruited Stanley Fischer to be on her team. The importance of her decision should not be underestimated.
Circumstances personal and professional having brought me a window into the mid-2013 decision of who would replace Bernanke as Fed Chair, I know that despite Yellen’s extraordinary and unquestioned qualifications for the position, her preparation for this “global organizational behavior aspect” was challenged.
If this nomination decision were based upon expertise across domestic regulatory and economic decisioning, most would agree that Yellen would have no peer. The global story is different. It requires a political strategist of the sort that can look above and beyond the borders of countries and their specific needs. This placed others of more system first, country second orientation in the mix, even one non-economist, due to his borderless viewpoint and firsthand experience in crisis management.
But the communications aspect ultimately reared its head in this decision. Who would be able to deliver us from years of Quantitative Easing without roiling markets? Who could be “the face” of that? The calm and measured Yellen, known for her courtesy, her dedication to logic and numerous incidents of overpreparedness, won out over more intense competitors. And consistent with the overpreparedness point, she came in with global political credibility at the ready.
Fischer, a man whose CV is not just impressive, but intimidating, is her Vice Chair. We know that Yellen, as Vice Chair to former Chairman Bernanke, had considerable influence on the Committee.
So, we expect, will Fischer. On that note, how might we describe Fischer’s guidance style?
To begin, I’ll draw a few lines from Fischer’s recent Per Jacobsson Foundation Lecture, which was given on 11 October 2014 in Washington DC within the context of the meetings of the IMF and World Bank. I am currently amidst review of all of Vice Chair Fischer’s recent speeches and lectures. While one speech alone is not evidence of communications style, this example is particularly helpful.
As an aside: I have recently enjoyed comparing the context Fischer creates in this lecture with the context offered by European Central Bank President Mario Draghi in his remarks on 27 November 2014 at the University of Helsinki. I’ll soon link to a shorter version of this analysis here, with the note for those not familiar that Mario Draghi was Professor Stan Fischer’s (PhD) student at MIT (1). It’s not so difficult to see the subtle influence of one on the other.
Fischer’s Per Jacobsson Foundation lecture offers one example of how to shift away from forecasting to context building, illuminating ways in which this creates a new perception for markets, sovereigns and the public following the Fed’s messaging pathway.
I will mention how a shift from forecast guidance to context guidance alters the role of probability models, considering that guidance involves establishing sets of outcomes and their likelihoods on a curve.
I am considering how the context approach to forward guidance alters the probability curve and how it is used by the Fed in its communications choices.
I will also note, for any who might be in doubt, that a speech by an FOMC member offered outside the scope of an official post meeting statement is to be considered forward guidance just as much as the official statement is. In an era of the Fed press conference and communications toolboxes, all Fed communications guide the market and economic expectations.
I make this point often around FOMC dissents. As each communication becomes a component of forward guidance, even dissents to the official statements are both useful and desirable. They enable more, (and more targeted,) messaging to the markets, sovereign states and the greater public. From my vantage, dissents are enhancements rather than concerns.
A few selected passages from Fischer’s speech illustrate its guidance purpose and importance.
We have done everything we can, within the limits of forecast uncertainty, to prepare market participants for what lies ahead.
This is a statement of transition. Of having completed a phase that was necessary to move to a subsequent phase. It notes the limits of forecast uncertainty, implying that the next phase of communications might seek to rise above such limits.
Fischer’s current Vice Chairship includes leadership of both the communications committee and financial stability subcommittees. This combination is not by accident. Financial stability is systemically focused by definition, and systems do not know borders as countries do. Systems are built of inventories, of stock and flow, of incentive and opportunity, of momentum and velocity. They are supranational in every sense. Financial stability, in combination with communications, creates a voice that speaks to the world.
Fischer offers us context:
…at first blush, it may seem that there is little need for Fed policymakers to pay attention to developments outside the United States. But such an inference would be incorrect…since the U.S. dollar is the most widely used currency in the world, our interests in ensuring a well-functioning financial system inevitably have an international dimension.
Fischer’s words guide us to a deeper view of what is necessary for the central bank associated with the world’s leading reserve currency. Note that he does not use the word “reserve,” however, as other currencies may be said to hold — or will soon hold — a valid reserve status.
Fischer says that the U.S. dollar is the most widely used currency in the world. Here he forecasts nothing, but contexts the following: the US dollar is the most trusted, and used by the most people for the most important purposes that a currency fulfills.
Boom. It gets better:
More tacitly than explicitly stated has been my view that the United States is not just any economy and, thus, the Federal Reserve not just any central bank.
Special rules, privileges and responsibilities typically rest with the gifted. By role, by custom and by obligation. Fischer continues:
The U.S. economy represents nearly one-fourth of the global economy measured at market rates and a similar share of gross capital flows. The significant size and international linkages of the U.S. economy mean that economic and financial developments in the United States have global spillovers—something that the IMF is well aware of and has reflected in its increased focus on multilateral surveillance. In this context and in this venue, it is, therefore, important to ask, what is the Federal Reserve’s responsibility to the global economy?
The context grows more powerful. A man who was the de facto head of the IMF through a substantial and decision-filled time is noting to an IMF audience that multilateral surveillance is necessary in a time of extreme interconnection. Yet it’s not just that everyone is connected; it’s that the United States is a key connection for just about everyone. What he’s just done is establish that oversight and regulation are essentially multilateral; i.e. supranational before they are national. (That’s a big one. Let’s pick that theme up in a future post.)
And with that, Fischer continues. He answers his own question: What is the Fed’s responsibility to the global economy?
First and foremost, it is to keep our own house in order.
I think this line is gorgeous.
In one sentence, it contexts the Fed’s domestic and international objectives as one unified effort, rather than a complex tradeoff.
In reality, it’s some of both — unified effort and complex tradeoff. But rather than forecasting with well-worded hesitancy within a domestically focused statement, leaving us to wonder about the “secret” global side of the picture, he describes boldly what the Fed’s real job is:
To keep the system stable and intact, to do that by keeping the US “house” in order, and, here comes the big part, to erase all concern that those two objectives are not in conflict.
Is that forward guidance? Yes. He’s guided, without issuing a forecast that he could get called on later. Beautifully done.
Fischer continues to tie the system and the mandates together:
Economic and financial volatility in any country can have negative consequences for the world—no audience knows that more than this one—but sizable and significant spillovers are almost assured from an economy that is large. There is no question that sharp declines in U.S. output or large deviations of U.S. inflation from its target level would have adverse effects on the global economy. Conversely, strong and stable U.S. growth in the context of inflation close to our policy objective has substantial benefits for the world. Thus, as part of our efforts to achieve our congressionally mandated objective of maximum sustainable employment and price stability, the Federal Reserve will also seek to minimize adverse spillovers and maximize the beneficial effect of the U.S. economy on the global economy. As the recent financial crisis showed all too clearly, to achieve this objective, we must take financial stability into account.
And here, he again reminds us what it means to be the keeper of the mighty US dollar:
Because the dollar is the primary international currency, we have, in the past, had to take action—particularly in times of global economic crisis—to maintain order in international capital markets, such as the central bank liquidity swap lines extended during the global financial crisis. In that case, we were acting in accordance with our dual mandate, in the interest of the U.S. economy, by taking actions that also benefit the world economy. Going forward, we will continue to be guided by those same principles.
Again, the systemic and domestic objectives are unified. In this context, an expansion of the Fed’s role is consistent with the Fed’s mandate as currently defined.
But the reason for all that he’s mentioned is financial stability. Therefore it can be said that the “f-stab” mandate sits alongside — if not often above, the mandates of price stability and full employment.
It’s an impressive use of words, one which states that the Fed has their own mandate which enables them to keep Congress happy and satisfied that the official mandates are being attended to as well. Fischer says the right words, but speaks them as a decision maker (not a taker of orders) would.
Considering that, let’s move back outside of our borders again. Fischer continues:
These financial stability responsibilities do not stop at our borders, given the size and openness of our capital markets and the unique position of the U.S. dollar as the world’s leading currency for financial transactions.
If the keeper of the dollar must also be the one to take care of the world economy, does that imply the Fed’s role as a backstop? Fischer anticipates this question, and throws a clever curveball in answering it:
My teacher Charles Kindleberger argued that stability of the international financial system could best be supported by the leadership of a financial hegemon or a global central bank. But I should be clear that the U.S. Federal Reserve System is not that bank.
This is the moment where a gasp is heard in the room. This moment, and its gasp, were undoubtedly intended. Fischer has just just assured us that he understands the multilateral and parental nature of the Fed’s — and US dollar and debt’s — roles in global stability. Yet he says, in sort of a revised twist version of Darth Vader in The Empire Strikes Back, “I am not your father.”
In other words, the Fed is very important, but it’s not your parent.
At this point, everyone wonders who is their parent. This is where Fischer breaks “the Fed as an entity” away from “the global system as an entity.” He’s saying they are both very important, and act in alignment, but are not the same thing.
This means that there’s a space in between them which must be acknowledged, respected, and even feared if circumstances make that necessary. There may be times when one acts above the other. Fischer continues by quietly instructing:
In this regard, we also should be realistic about what a backstop is. Any global backstop or liquidity facility should have certain features—accountability and monitoring, some degree of stigma in good times, and a high hurdle for usage. In other words, backstops are not built to be liked.
In other words (I paraphrase,) “I can help you, and I want to. But I do not wish to be taken advantage of. Don’t go there with me.”
Or a third, somewhat chillier but also plausible version? (again, I paraphrase,) “The stability of the global system comes first. Not you. Consider yourself informed.”
Nicely done. It is an ideal lead in to normalization, also known as “the proposed near future reintroduction of an operable pricing mechanism.” In the context of Fischer’s speech, normalization is not just about the United States. Rather, it is global, precisely because what happens in the United States is also global. The context of one is the context of the other.
In the United States, we are working to ensure that our financial institutions and other market participants are prepared for the normalization of monetary policy and the return to a world of higher interest rates. It is equally important that individuals, businesses, and institutions around the world do the same.
For our part, the Federal Reserve will promote a smooth transition by communicating our assessment of the economy and our policy intentions as clearly as possible.
As clearly as possible. We will not rely on a forecast that may or may not be fulfilled, and may or may not be taken seriously. We will describe the pathway as we go, so that you may understand our way and understand what your tasks will most probably be on our shared normalization journey.
Here’s a question that I would have wanted someone in the room on 11 October 2014 to ask:
Dr. Fischer, might you describe how this changes our probability-based models? We are accustomed to dealing with “forecast” sorts of forward guidance.
Chair Yellen’s “forecast preference” in which “achieving transparency” and “surprising no one” are key objectives, presents (in theory) a narrower range of outcomes than would a context format as Fischer has offered.
Those who watched the 17 December 2014 Yellen press conference know that several journalists challenged that theory, asking if confusion, misunderstanding — and with it a far less limited range of possible outcomes — could be assumed.
I would suggest that Fischer’s context preference for guidance is both more certain and less limited. He is designing a context which will influence probability models in a certain way, but in doing so he is not limiting and managing the number of models as a Yellenesque forecasting preference might.
In choosing a forecast preference Janet Yellen presents a narrower though unexact range of probabilities So, disregarding possible paths in between for the moment, one either reviews the Statement of Economic Projections (SEP) and her words and models within that range of assumed outcomes, or one chooses not to take this forecast nor its implied range seriously.
Fischer has a range as well. While it is contextual rather than number specific, it’s far harder to act outside of it, i.e. reject or ignore the range as some are doing now.
A managed move from “surprising no one” to contexting shift can be viewed as a move toward prohibiting rejection of the implied range — or, in other words, making extra-range decisioning not just illogical but irrelevant.
I may expand upon this point in a follow on post, in which I’ll consider yet another question and answer from Yellen’s December 2014 press conference. The question was from Steve Beckner of MNI. While somewhat basic at the outset, it turned out to be a valuable addition as it resulted in Yellen talking about stock and flow and the function of the Fed’s balance sheet.
In preview, and to wrap up this post, I’ll return to Fischer’s speech, and his forward guidance “style” and mention Millennials. Specifically, Millennial market participants, whom I’ll use as a proxy for all newer market participants for the moment.
Yellen’s transparency around interest rate plans, however sincere, is somewhat abstract to a banking cohort that has lived more than six years in the zero lower bound. Consider that bankers, investment managers and even entrepreneurs in their early 30's and younger have never really experienced an interest rate in their professional lives. (It’s hard to imagine for those of us who worked on a fixed income desk before this all came to pass.) But this is indeed how they live.
Normalization will not be a return for them. It will be new, and they will need to be educated. As of now, they have plenty of forecasts, but they lack the context by which to comprehend them.
Many are newer to the business, and do not realize that they are living in an unusual, pricing mechanism-free version of financial time. Such views, I have often suggested, may come to explain the gaps in expectation between the Fed and markets that we have seen over recent months.
While Yellen’s forecasts about data-driven rate direction may seem abstract (or even voluntary?) to a Millennial-aged banker, the narrative Fischer is guiding may be more tangible to them.
Millennial and newer market participants know that there was a crisis, and that the crisis was managed by introducing liquidity, confidence, and a place to run to in a panic. A place with enough space for all.
As they see it, it is the role of the central bank to provide these things:
- to ensure the constant availability of an ultrasafe unbreakable asset. It is that asset, not necessarily a pricing mechanism, that sits centrally to their planning;
- to ensure enough of the ultrasafe to flee to (so that there isn’t a panic for limited supply);
- to ensure ample liquidity to move around and have choices at all.
To a generation without an interest rate, these three things have to exist whether there’s a rate mechanism/normalization coming up on the journey or not.
To them, the bank supports or saves, depending upon the phase.
To return that perception to a historical normal represents a complex challenge for central bankers. One which Fischer’s characterization of backstops in his 11 October 2014 speech guided toward, but did not resolve.
What Fischer describes as “keeping our house in order” is in fact keeping the world confident that the US can do the three things I’ve just listed. Even in the face of necessary and/or disruptive moves to an operable interest rate.
Perhaps the issue with Yellen’s forecast style is that it attaches normalization to an interest rate hike in the minds of the market and public.
This infers a tightening of conditions, rather than a return of order itself. It may suggest improper application of a 20th century hawk-dove scale to a 21st century shift that has little to do with it.
Fischer’s context style is much more subtle and suited to a more macroprudential, global stability focus for the Fed as it reintroduces a rate mechanism off of zero, a necessary step which only the world’s leading central bank can legitimately take. Fischer’s context building convinces those guided to trust the United States Federal reserve, because the United States is not just any economy and, thus, the Federal Reserve not just any central bank.
One of my predictions for 2015, which we may see even as soon as the March 2015 FOMC presser, is a move away from forecast and a move towards context in communication.
Yet I must emphasize that Yellen’s and Fischer’s style choices are not contradictory. Rather, they complement each other within a normalization framework. Yellen’s recruitment of Fischer appears to be a sharp and timely management decision. While I can only surmise at this early stage, I think history will treat Yellen’s transition role in normalization quite positively, even if she encounters challenges in getting market participants to align with her during the process. (I think she will encounter such challenges.)
In my recent post, Here There be Dragons, I metaphorically depicted Yellen informing both passengers and passersby of the pathway of her ship. Does Fischer’s style do so as well? Yes, and no.
Consider this somewhat lightweight analogy, until I come up with a far better one: rather than telling you exactly where the ship will steer but being vague on the timeframe of arrival or precise speed lest the passengers try to “game” the route, a contexting forward guidance will describe the quality of the cruise itself.
The details of the view, the lounge chairs, the entertainment and buffet offerings, and where you might find the gym if you decide you need it after the buffet offerings. And in describing the smoothness and sureness of your travel experience, implicitly ensure the smoothness and sureness of the vessel as well.
It’s an amusing analogy, but it’s not entirely off base.
As I continue to review recent speeches and communication by Vice Chair Fischer, toward examining and comparing his style both versus and as integrated with Yellen’s, I will note the ways in which the styles combine towards engaging a stable configuration moving forward, and how they succeed in convincing the markets to “travel” along with them.
I will pay close attention to decision ranges and probabilities introduced by each, toward analyzing the shifts in decision patterns in market participants 1) proximate to the FOMC and 2) further from it in geography, market served or generational (Millennial) terms.
To be continued.
I am on Twitter @WaterandWool
Image two: Bloomberg News
Image three: NORTH NEWS