Managing Expectations—The Fed’s Two-Edged Sword

Popular Economics Weekly

It does look like the results of Fed Chairman Bernanke’s push for greater transparency in Federal Reserve policy deliberations are coming home to roost. Stock and bond prices have been whipsawed since Bernanke made the seemingly offhand remark that QE3 security purchases could be cut back by the end of the year.

Just what did Bernanke’s Fed expect, in their crusade to manage expectations for greater growth with the printing of so much money? Its seems to have backfired, at least for the moment. The market plunges that resulted from his remarks are testament to the fact that investors believed any hint of higher interest rates could slow down or even halt the recovery. The markets obviously believe the recovery isn’t yet strong enough to tolerate higher interest rates, contrary to the Fed’s own expectations for growth.

Paul Krugman said it best in a recent blog post: “What went wrong? The Fed grossly misunderstood the nature of the relationship between its statements and market expectations. It believed that the market was listening closely to the details of what it said. In fact, the market doesn’t — and probably shouldn’t…what the Fed conveyed with the tapering talk was a sense that its heart really isn’t in this stimulus thing.”

So Bernanke’s crusade for greater transparency can be a two-edged sword, in that the underlying reason for greater transparency was to test how well the Fed could manage expectations for greater growth—by pushing both short and long term interest rates to record lows—thus telling consumers and businesses they could borrow cheaply with overly optimistic projections for future growth.

But as former Fed Chairman Alan Greenspan once said; “Human nature being what it is, the vast majority of us are disinclined to offer half-thought-through, but potentially useful, policy notions only to have them embarrassingly dissected in front of a national television audience. When undertaken in such a medium, deliberations tend toward the less provocative and less useful…The undeniable, though regrettable, fact is that the most effective policymaking is done outside the immediate glare of the press.”

Fed Governor Jerome Powell was one such example, when he tried to mitigate Bernanke’s remarks. “The reaction of the forward and futures markets for short-term rates appears out of keeping with my assessment of the [Federal Open Market] Committee’s intentions, given its forecasts,” Mr. Powell said. “To the extent the market is pricing in an increase in the federal funds rate in 2014, that implies a stronger economic performance than is forecast either by most FOMC participants or by private forecasters.”

And that is what happened. The Fed Governors attempts at greater transparency have come out as conflicting statements and speeches—maybe well thought out, but nevertheless confusing.

Then came the revision of Q1 GDP growth downward from 2.4 percent to 1.8 percent, largely on downward revisions to consumer spending. So right away we see that Bernanke’s basis for his optimism was being cut away. Faster growth may not be with us, as least not in the foreseeable future. So maybe it’s not such a good idea to attempt to ‘manage’ expectations. Or maybe the Fed doesn’t have a good read on what those market expectations are, which can be a sword that cuts both ways!

Harlan Green © 2013

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