The Fed communication conundrum

The Federal Reserve meeting on the 17-18 Sept has become a singular focus by many in the markets that are obsessed with the prospect of reduced bond purchasing from the Fed.  This is important for all markets given the huge sell off in US bonds has been an important catalyst for movements in emerging markets as well.

Its not clear from the key data since the last announcement that the case for changing the current stance of the FOMC is particularly strong. On balance, the data has been on the weaker side, particularly in the key employment and inflation releases. (clicking on the image on the left expands the table).

It also seems likely that the Fed will have to revise its growth and inflation forecasts lower, which will be released following this meeting. Can the FOMC really say that things are going as planned and credibly downshift their numbers? I don't think so.

This communications challenge is now particularly acute because the sell-off in bonds has been more aggressive than the Fed would have anticipated given economic outcomes and the fact it is only guiding for slowing the pace of purchases rather than ending them altogether.

To be sure, because the sell-off at the longer end of the curve has been so aggressive, selling pressure is now moving into the shorter end of the curve as well.

The spread between 2 and 10 year Treasuries has widened to levels seen back in 2011, when there were hopes that policy action at the point has generated a sustainable recovery.  But because the sell off in 10 years has been so aggressive, 2-year yields have started torise, which are up ~25bps from the lows at 0.50%

A rally at the shorter end of the curve isn't really what the FOMC are guiding for.  While they seem uncomfortable with the risks of continuing to buy treasuries at, they do want to anchor expectations at the Fed Funds rate will remain at the lower bound for at least the next couple of years.

This perhaps speaks to the broader problems of the Fed's current strategy.  Its becoming apparent from speeches from members from the FOMC and research from Jackson Hole that additional purchases of Treasuries are creating more risks than rewards.

But all central banks now appear to be enamoured with "forward guidance" which amounts to promising to keep rates anchored dependant on economic outcomes. Below is the FOMC's most explicit guide the members expectations, with the vast majority expecting the Fed Funds rate to be unchanged in 2014 and lifted somewhat towards the end of 2015.  I don't expect this profile to change at the next release in a couple of weeks.

The problem for the Fed at the moment is that in the markets view the action of slowing of QE speaks louder than the words of forward guidance.  Perhaps this sell off is an illustration that the academic studies on the virtues of forward guidance is perhaps not as great as it seems.

Ideally the FOMC will be able to convince markets that while the process of winding down purchases of Treasuries brings the point of rate hikes closer, it is perhaps not as close as they are currently anticipating.

If they are successful in doing this then they should be able to re-anchor the shorter end of the curve at current or lower rates than today.  The means that a further sell-off at the longer end of the curve will be dependant on whether the market will want to push the yield curve steeper.

But this process is unlikely to be smooth.  Indeed, the lack of communication from the Fed suggests they are not entirely sure what to do at this stage.  I tend to think that the "will they, won't they" view on tapering is perhaps missing the bigger picture, with the Fed likely to come out with stronger language than they have used in the past on guiding for a low Fed Funds rate for longer.