Forward Guidance Failures

We Can Hear You Now

One of the themes I’ve discussed in recent months is the disconnect between a 40 year high in inflation and the lack of experience money managers have in understanding the monetary policy required to deal with such high inflation, including managers with 25 to 30 years of experience. The views of the majority of money managers in 2022 have been shaped by the last 20 years. Money managers learned that when the going got tough the Federal Reserve always came to the rescue. This experience generated the fervent belief in the “Fed Put”. What they haven’t understood in 2022 was that the Fed was previously able to respond with accommodation when trouble appeared because core CPI inflation stayed below 2.5%.

More importantly, the Federal Reserve’s preferred inflation gauge is the Core Personal Consumption Expenditures Index (PCE) and, other than the period of 2004 – 2007, the Core PCE has been less than 2% since 1996. That changed in 2022 but money managers have expected the FOMC to respond as if inflation was still hovering near 2.0%.

The FOMC publishes the minutes of its meetings 3 weeks after a meeting and it’s common for the minutes to show a decent level of discussion and at times a disparity between various members’ views. Often the Doves and Hawks on the FOMC express an opposing view of what the appropriate policy should be. (Think of Dove Kashkari, and Hawk Bullard) This is why the uniformity in the past six months is noteworthy. Rather than different members offering contrasting views about future monetary policy in speeches and interviews, there has been broad agreement. The Federal Reserve believes Forward Guidance plays an important role in communicating to financial markets the direction of monetary policy. The FOMC believes that its Forward Guidance will minimize surprises and prevent excessive volatility.

The heavy use of Forward Guidance last year by the FOMC created a huge problem for the FOMC in 2022, as countless speeches expressed confidence that inflation would be transitory proved spectacularly wrong. This big miss damaged the FOMC’s credibility. In March and April there was broad agreement by FOMC members that the FOMC would increase the Funds rate to the neutral level (2.50%) as expeditiously as possible. Initially financial markets didn’t believe the FOMC would act decisively. When the markets finally realized the FOMC would follow through, the S&P 500 dropped from 4600 in early April to 3637 in June, and the 10-year Treasury yield jumped from 2.42% in April to 3.47% in June. This is an example of investors not heeding the FOMC’s Forward Guidance, even when the messaging is explicitly clear. In April Forward Guidance failed because investors failed to hear the FOMC’s message and doubted the FOMC’s conviction to deliver.