Here There Be Dragons?

Notes following Fed Chair Janet Yellen’s 17 December 2014 Press Conference: Communicate Transparently; Surprise No One

ROBIN HARDING. Robin Harding from the Financial Times. Madam Chair, there’s a big gap between the pace markets expect you to raise interest rates and the rate you’ve indicated in your dot plot. Are markets misunderstanding your intentions? Thank you.
CHAIR YELLEN. So that’s difficult for me to say. What I want to say is that our objective is to communicate as clearly as we possibly can about our plans and how we see the economic environment unfolding.

Wednesday, 17 December marked Janet Yellen’s fourth press conference as Chair of the Federal Reserve.

Her first, in March, considered tapering, Ukraine unrest, and whether considerable time could be defined as “six months.” June and September’s press conferences each weighed the meaning, method and management of a near term exit from Quantitative Easing (QE) and how to define and communicate future phases of “normalization” to both the markets and public.

The September meeting also responded to policy surprises (and negative rates) from Europe and the shadows and opportunities of a Scottish referendum widely seen as a test case for smaller states combining voice and exit approaches to address lapses of supposedly representative governance.

Having achieved a bit of distance from the end of QE and Halloween surprises from Japan in late October, December brought sharp drops — in oil prices and the Russian ruble. It’s been a tumultuous year, but in many ways a fortunate one for Janet Yellen. A chair known for her courtesy, thoroughness, seriousness and methodological approach led the world out of US QE with a charming smile. All while sticking to her own agenda.

This may be the last year she gets to do that. When then-Vice Chair Yellen was nominated by President Obama for the Fed Chairship in October of 2013, I expressed relief at the choice but noted that her task was not for the faint of heart. While I am cheered by her steady focus shown across 2014, I know that 2015, the year normalization probably begins, is truly uncharted territory. As maps of old warned sailors who dared sail off into parts unknown, here there be dragons.

As an unprecedented process of normalization is engaged following an unprecedented six plus years of life in the zero lower bound, the pathway into 2015 and forward looks less certain than ever. Even as most of 2014 was spent in diligent preparation for a journey into the unknown.

While preparation is always wise, it is not always enough.

I cannot know exactly what will happen next year. Yet I know it will present complex tradeoffs, and with them decision processes that may expand the role of the Fed in global financial decision making.

In some cases the Fed will collaborate with other central banks in effecting system-level policy above and beyond the direction of sovereign states and their governments. At times, system-focused actions may opt to put the domestic priorities of specific regions on hold. This will happen in the name of financial system stability.

Whether or not such suprasovereign normalization phase authority becomes permanent to central banks is a question for us to return to a year from now, and in years beyond that.

Fed Chair Janet Yellen’s first directives, as she enters 2015?

Communicate transparently. Surprise no one.” Not even the dragons.

Dragons, everywhere.

Steering the Ship, Patiently

As I have noted on other occasions, for our part, the Federal Reserve will strive to clearly and transparently communicate its monetary policy strategy in order to minimize the likelihood of surprises that could disrupt financial markets, both at home and around the world. More importantly, the normalization of monetary policy will be an important sign that economic conditions more generally are finally emerging from the shadow of the Great Recession.

-Chair Janet L. Yellen at the “Central Banking: The Way Forward?” International Symposium of the Banque de France, Paris, France, 7 Nov 2014

There was a time when the Federal Reserve trusted the reparative power of surprises. It was an era in which central banks existed in the background and adjusted dials and levers. They reacted to hot and cold conditions by making sure the economic porridge was just right.

It’s easy to think back to days long before press conferences. Especially as Chair Yellen entered the room on Wednesday afternoon to the usual audible and brilliant array of flashbulbs. Having just seen the ECB’s new press room in Frankfurt, an angular, airy, steel and glass building extension which simultaneously evokes a hovering spaceship and an ultramodern cathedral, our same old Fed room, built for pre-presser days, looked almost quaint.

Yet so much has changed, from words chosen to roles played. And more will change. Ironically, those in the ultramodern space will listen very well to those in the quaint one.

Yellen’s remarks in Paris in early November reiterated her directives mentioned just above. Transparency. No surprises. Implicit in both of them: the Fed is ahead.

It is leading all other participants: its fellow central banks, sovereigns, and markets. Ensuring stability through a normalization phase that involves all parties mentioned.

While the 17 December statement again included reference to “considerable time” prior to the official onset of normalization action, in the form of an upward adjustment to interest rates, it added the word “patient.”

While one or two dissenting FOMC members might disagree with me, “patient” is not a time dependent word. It is qualitative, and it infers that one has the privilege of waiting, i.e. is free from the coercion of others who might wish it to act. The term communicates that the leading voice in the financial system, the ultimate mapmaker for travel to places still unseen, is going to steer in a rational, firm and methodical way. Patiently. Unjittered by individual events. With full transparency of forecast and policy across the journey.

Done with reacting to and fixing up the work of others, and done with relating future actions to a quantitative easing phase that’s now, in Chair Yellen’s own words, “receding into history,” the Fed is establishing the pathway forward.

Theirs is the forecast to guide all forecasts, the ship to guide all ships. Ignore it at your peril.

But some question whether this role is one that the Fed should assume with such an air of permanence.

Via Michael Derby, Wall Street Journal, 13 Nov 2014:

A 2% inflation target? Long-term, detailed forecasts of activity? Pledges to keep rates very low well into the future? For Mr. Volcker, who led the Fed from 1979 to 1987, these are all overly precise policy choices that promise more than any central bank can deliver. What’s worse, the policies that have come to define modern Fed policy can even be counterproductive, making central bank goals harder to achieve.

Clearly, former Fed Chairman Paul Volcker knows what it’s like when the Fed takes charge. His comment in challenge to Yellen’s forecasting preference is worth noting because his actions involved doing what was necessary, however harsh or unpopular it seemed.

But Volcker’s actions were time-limited and crisis specific, not intended as everyday practice or a new norm. Secondly, they had a known lever, a known rulebook, and associated credibility behind them.

Chair Janet Yellen’s situation is different. She approaches normalization, widely viewed as a phase leading to permanent revival of a suspended interest rate mechanism, with an unwritten rulebook, a complex set of tools far beyond “the lever,” and a never-navigated map for escape from six plus years in the zero lower bound.

Her credibility must be earned and won moment by moment, press conference by press conference. Volcker did not have regularly scheduled press conferences. While I have not asked him this directly, I imagine that he is glad that was the case during the era in which focused upon restoring confidence and price stability to the US economy.

On that note of credibility and press conferences, let’s return to Mr. Harding’s excellent question which opens this post.

Yellen wishes to surprise no one. Yet markets seem to be acting differently than expected. He asks,

Are markets misunderstanding your intentions?

Or, paraphrased,

Madam Chair, did they hear you correctly?

Assuming that Yellen’s commitment to transparency would yield uniformity across constituent reaction, why are some market participants acting differently than might be expected? It’s an observation which links Harding’s question to two other spot-on questions that Yellen received, from The Economist’s Greg Ip and Marketwatch’s Greg Robb. All three called attention to a layering of messaging, with markets hearing one version even as the public thought they heard another.

Listening well.

Central bank press conferences demand an attentive ear. They are typically well-woven combinations of scripted and unscripted questions and answers, and knowing which is which is key to understanding what is being communicated.

This past September, I shared ongoing work taking place at the San Francisco Fed (which is only a block’s walk from the office I’m in right now) regarding the “spread” developing between expectations of market analysts and Fed forecasters. Why was the market reacting as if easing would not end, when Yellen said clearly that it would? Considering this ongoing trend, Yellen’s almost definite statements of the onset of rate adjustments as soon as mid-2015 were expected to incite reaction.

To Harding’s question: Do the markets hear something in Yellenspeak that others don’t? Or worse, do they simply not take Fed forecasts seriously?

Yellen reiterated her two directives, as she had in Paris in November. Her response to Harding, (as well as her response to Ip, which I will approach just following) reaffirmed the Fed’s role as prescient communicator, but were ultimately less than forthcoming. She did not let on whether certain segments of the market, in flaunting their apparent “misunderstanding” of Fed hints, nudges and Statements of Economic Projections (SEP) around a higher probability of nearer term rate adjustment, were an issue or not.

Follow the leader. Watch out for icebergs.

If segments of the market are indeed ignoring the Fed’s forecasting, Harding’s question is quite significant. Many seasoned Fed watchers (here’s a link to a brief overview that economist Tim Duy (University of Oregon) shared just following the press conference) noted that Chair Yellen removed all reasons for doubt that action on the rate front could come as soon as this June. The Wall Street Journal shared a link to post-meeting commentary by Tom Porcelli, Chief Economist for RBC Capital Markets, which begins unmistakably: “The FOMC statement was hawkish. Full stop.”

But markets considered “friendly” to past easing did not react accordingly. Perhaps they did not hear the language as hawkish, or dovish. Perhaps they acted as those would if they considered the instructions to be temporary, rather than firm. Perhaps June 2015 seems all too far away, an uncertain time that cannot yet be imagined beyond its outlines.

Yellen’s comments appeared to imply this:

If the Fed indeed leads the way, it will be the market’s wise duty to fall in line. If it does not, instability could result which could delay or unsettle normalization agendas.

Volatility possibilities aside, a gap of this type will need to be dealt with collaboratively as the existence of two parallel expectations sets will not increase overall confidence in the type of intermediate-to-longer term investment that would necessarily accompany a successful normalization phase as the Fed envisions around a coming rate adjustment.

Note that I have used the term rate adjustment, not rate rise to describe the soon upcoming normalization phase. I have done so on purpose. I will address this within my discussion of Greg Ip’s question.

The Hawk Dove Scale’s Apparent Insufficiency

GREG IP. (The Economist) Chair Yellen, the committee’s projections show unemployment running below your own views on where full employment should be for the next several years. Does that reflect a desire on the part of the committee that the economy runs somewhat above potential for a while? And if so, can you elaborate on why it wants that and what purpose it achieves?
And related to the question that Jon Hilsenrath (Wall Street Journal) asked earlier, you’ve called the decline inflation market-based measures of inflation expectations transitory. But this decline has been very pronounced in the five year forward range. So we’re talking about expectations that inflation many years from now will be below target. And some market participants see that as evidence of declining credibility in the committee’s long-term objective. Why do you still view that as transitory?

Following the press conference, Ip wrote this piece for The Economist. It’s a helpful recap of key points from the meeting, and it offers additional context to his questions to Yellen.

The second part of Ip’s question directly challenges Yellen around inflation expectations anchoring, a topic quite familiar to those of us who follow press conferences held by the ECB. Following upon Harding’s question, Ip asks Yellen to comment on the difference between the FOMC’s firm view of inflation expectations and the market’s less sure and lower expectations, as indicated by the five year forward. His first question, following upon Jon Hilsenrath’s question, asks whether the employment target is really what we’re talking about here. Ip gently linked Hilsenrath’s presser-opening question to a larger topic which gave it additional depth on the second go.

The following paraphrasing is mine:

The Fed’s actions don’t quite match its traditional, assumed role. You’re saying that decisions are data dependent, yet you’re acting as if something else is going on here.

What if something else is going on? As I shared in a post on Facebook on Thursday morning, 18 December 2014,

What Ip is saying is that there appears to be a break between current forward rate decisioning and traditional bases for rate decisioning. This doesn’t mean that decisions are no longer data dependent; certainly they still are to some if not a great extent. It means that the rationale and geographical scope for rate change may not be what has been previously assumed.

To many observers, Yellen appears to be hawkish and dovish all at once. Those who exhibit great devotion to the hawk-dove scale in its 20th century form might complain that Yellen is acting in a contradictory, even confused fashion, focusing too closely on the accuracy of words instead of deeds.

Yet Ip wisely leaps past this easy route of complaint, and I am pleased that he did. Normalization in 2015, as I’ve indicated above via various map and dragon metaphors, is a venture into uncharted waters. The hawk-dove scale is insufficient to describe it. In other words,

The hawk-dove scale is outdated.

I must disclose here that a year or so ago I began designing a new 3-dimensional scale to replace the old hawk and dove continuum. The design made its way into a research proposal I completed in mid-November of this year; it is now in initial academic review. So I come to this topic with views that normalization following an extended crisis-induced zero lower bound involves the reintroduction of a trusted, operational pricing mechanism for risk. A reintroduction is a “phase next,” or “exit,” not a rate rise, or “fix.” In other words, zero is not a low rate, it is an absence of a rate, and a departure from zero is effectively an introduction of a new mechanism. Were this a mere rate rise, driven by the usual conditions in which rate rises happen, we would see decision align with data in a far closer way than we’re seeing now. Please see my recent post, Games of Musical Chairs, for additional thought on this point.

It’s not that Yellen is playing the game incorrectly, as some might accuse. She’s playing a new game. Judging by old rules will probably yield a confused (and purposeless) result.

As before indicated, the Fed is now leading, not reacting. That reaction phase is receding into history. Viewed in such a context of shift, the term “patient” is beautifully selected. And the statement “Hawkish. Full stop,” is potent, but less applicable.

Returning to Ip’s push on Yellen’s frequent use of the term transitory, a deeper question is why Yellen seemed to look above and beyond recent drastic drops in oil prices as a disinflationary influence, one which might embed into intermediate term expectations — and therefore Wall Street’s investment willingness — regardless of whether oil prices recover or don’t into 2015. I’ll consider this within review of Greg Robb’s question to Yellen, which addressed potential shock and destabilization effects of high yield debt in a volatile and uncertain time for oil.

Is that other ship following, or not?

Like Harding and Ip, Robb asked Yellen if the markets were not heeding her advice.

A Transitory Themesong

Oil prices are a key ingredient in the soup of inflation and its expectations, and rapid unanticipated price changes in oil, up or down, can wreak havoc on expectations globally.

While I will focus on Greg Robb’s question, I must mention Steve Liesman’s (CNBC) framing question earlier in the meeting. Yellen’s reply to Liesman covered a range of current effects and future possibilities concerning oil’s effect on both the economy and FOMC decisioning:

CHAIR YELLEN: The very substantial decline we have seen in oil prices is one of the most important developments shaping the global outlook. It will have different effects in different regions, and could well have effects on financial markets, as we are seeing. I think the judgment of the committee is that from the standpoint of the United States and the U.S. outlook, that the decline we have seen in oil prices is likely to be on net; a positive. It’s something that’s certainly good for families, for households. It’s putting more money in their pockets. Having to spend less on gas and energy, and so in that sense, it’s like a tax cut that boosts their spending power. The United States remains — although our production of oil has increased dramatically — we still remain a net importer of oil.
Of course there may be some offset in the form of reduced drilling activity, and possibly some change, some reduction in CAPEX plans in the drilling area. But on balance, I would see these developments as a positive for the standpoint of the U.S. economy.
With respect to deflation, we see downward pressure on headline inflation from declining energy prices. We certainly recognize that that is going to be pushing down headline inflation. And may even spill over to some extent to core inflation. But at this point, although we indicated we’re monitoring inflation developments carefully, we see these developments as transitory.

Yellen used the word “transitory” quite a few times across the press conference. By the end of her replies to Hilsenrath and Liesman, who were questioners one and three out of fifteen, we knew it was going to be a themesong.

In a way, it was a message of assurance. The firm hand of the Fed was not going to tremble or waver in the face of every little storm. It was going to steer ahead through this hiccup. This is all transitory.

This may turn out to be right. But Robb’s question pushed back on this assurance. He mentioned contagion risk.

In reply, Yellen didn’t waver. She almost doubled down on her original points.

GREG ROBB. (Marketwatch) There’s a contagion risk to the — from low oil prices that people are talking about in the markets. What does it mean to the banks that have lent, you know, into the oil patch with the low oil prices? And I guess, you know, your warnings about leveraged loans. You have made warnings over the past year about leveraged lending. Are you worried that they haven’t been heeded? Thank you.
CHAIR YELLEN. So I mean there is some — you’re talking about in the United States exposure? I mean we have seen some impacts of lower oil prices on the spreads for high-yield bonds, where there’s exposure to oil companies that may see distress or a decline in their earnings, and we have seen some increase in spreads on high-yield bonds more generally. I think for the banking system as a whole the exposure to oil, I’m not aware of significant issues there. This is the kind of thing that is part of risk management for banking organizations and the kind of thing they look at in stress tests. But the movements in oil prices have been very large, and undoubtedly unexpected.

While I will leave an overview of the combined gift and dilemma oil price drops present to the US Economy and ultimately to Wall Street to another post, (you can start reading here and here ,and view this Financial Times video as well) the concern Robb speaks of is very real. Versions of this question were shared amongst Fed watchers prior to this meeting; this post by Tim Duy raises the high yield debt question as a source of the undesired and unexpected, one to which a stability-focused FOMC must respond.

Duy’s tweet above calls Yellen’s calm delegation of the issue a “bullish” sign. While an accurate description marketwise, I saw it as a response by a Fed Chair who knows it would be perilous for her to mention any segment of the market as a source of potential near term instability even if all evidence says it could be.

A story of excessive leverage taken in a market which assumes that prices of its good will stay stable or rise should sound familiar to you. Put simply, a roaring market will last precisely as long as the lenders lend into it. Yet the moment that falling prices start taking operators out of the market, and industry consolidation (which I expect we’ll see in 2015) is no longer a viable or rapid “bridge” option, defaults can begin. Once one Wall Street Firm or fund dumps its high yield debt positions, others will follow, and intervention to stem panic may be required.

Yellen’s reply mentions risk management as a firm function. She’s correct. Yet the Fed is in a position to see in the macro what firms see in the micro, so this is not a matter she can separate entirely.

Yet this point is not the issue, nor do I question her awareness of the potential risk here. The issue is that she can’t talk about this risk in a press conference. So we get a non-answer rather than no answer at all. (Former Fed Chair Paul Volcker, I imagine, would prefer that quieter “no answer” option.)

Her placid non-answer to a provocative question leads to a larger observation: Chair Yellen doesn’t really answer non-domestic questions in press conferences. When she receives them, she is well-scripted, adept, concise and promptly dispatches the matter as something that the committee “has discussed.” Non-domestic questions aren’t just about oil or Russia or emerging markets. They are also about currency, and how a strong US dollar (vs. the euro and the yen in particular) effectively tightens conditions without any sort of rate action. They are also about the Overnight Reverse Repo Program Facility, which is still in test phase and is showing early signs of becoming a major, and perhaps disentermediative, presence in the sovereign-dominated global bond market.

There are well-known rules of what the Chair isn’t going to say. For example, if she’s asked a specific question mentioning Goldman Sachs (Pedro daCosta, Dow Jones Newswires, specifically referenced the firm in his question this past Wednesday) her answer will not identify specific firms. But the international area is still murky. Bernanke also managed to avoid it.

I’m unsure whether that convenient situation will continue, though I acknowledge that there are reasons that it should. An opening into globally focused thinking might take the FOMC away from Chair Yellen’s commitment to communicate transparently, and surprise no one.

I approach these points in my follow on post titled “A House in Order.” The title is drawn from Vice Chair Stanley Fischer’s Per Jacobsson Foundation Lecture, given on 11 October 2014 in Washington, DC during meetings of the IMF and World Bank.

I may also call out an “honorable mention” questions from the 17 December 2014 Press Conference, (see image to the left for a clue to which one) and call attention to how dissents are useful to the FOMC’s communications function.

Last but not least, what might we expect in Yellen’s March 2015 appearance? I’ll share a few thoughts.

I am on Twitter @WaterandWool

Video of the 17 December 2014 Press Conference is here:

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