Has the Fed Lost Its Credibility?

Markets Confused by Ongoing Fed Uncertainty

A volatile week ended in modest fashion, as the S&P 500 finished with a 1.3% gain and the Dow Jones Industrial Average rose 0.5%.

Economic data was mostly positive on the week, but the dominant headline was the decision not to taper asset purchases by the Federal Reserve. Otherwise, housing posted positive gains in August, as did industrial production and the index of leading economic indicators.

Dominating all other headlines this week was the FOMC meeting that concluded Wednesday. Many were expecting the Fed to scale down its asset purchase program by $10 to $20 billion, but instead, the Fed voted in favor of delaying any action. Citing tightening fiscal conditions, weak inflation trends, and modest improvement to labor markets, the FOMC felt it was prudent to continue asset purchases at existing levels.

During the Q&A session, Fed Chairman Bernanke provided additional color for the decision, pointing towards many issues for the economy, including the upcoming fiscal debates.

On Friday, James Bullard, President of the Federal Reserve Bank of St. Louis, was quoted as saying it was a “borderline” decision and the committee could be “comfortable with a small taper in October.” Those comments are credited with causing uncertainty in the market and sending risk assets to losses on the day.

All the while, the budget battle is heating up, with the House of Representatives moving to pass a continuing resolution that defunded the Affordable Care Act. There is a possibility that a compromise is not reached, causing a government shutdown and breach of the debt ceiling. That would be an undesirable outcome for the economy and one that politicians will seek to avoid at all costs over the course of the next few days.

Despite the Fed’s fears, the economy showed some signs of life last week, particularly in housing and industrial production.

Existing home sales for August reached a 5.46 million annual rate, which is the highest level since February 2007. Concerns about the impact of higher mortgage rates proved unfounded, but housing affordability did decline in the month because of the 30-year mortgage rate going to 4.5% from 3.6% one year ago.

Source: Haver Analytics

In the manufacturing sector, industrial production rose 0.4% in August, similar to expectations. Offsetting the gain, July figures were revised from -0.1% to -0.4%. Manufacturing was up 0.7%, with strength from auto production.

Source: Econoday

Consistent with the Fed’s comments about weak inflation trends, the consumer price index (CPI) posted a 0.1% increase in August and is up 1.5% in the past 12 months. Falling energy prices played an outsized role on depressing the headline figure, but inflation trends were muted across the board. Weak inflation growth presents a very real problem for the Fed, as any measures to tighten policy could push inflation even lower at the risk of deflation.

In other news, incumbent Angela Merkel won the chancellorship of Germany for a third term, according to preliminary results. Merkel’s political party dominated the polls, winning 42% of the vote. The Christian Democratic Union (CDU) narrowly missed achieving an outright majority in the legislature, which will necessitate Merkel to form a coalition with another party.

Has the Fed Lost Its Credibility?

Any economics student will tell you central banks must achieve three things to effectively implement monetary policy: (1) independence; (2) credibility; and (3) transparency. For most of the Fed’s history, the first two characteristics were arguably well attained. However, the group was never well known for clarity into its thinking.

During the Bernanke-era, the Federal Reserve has made tremendous advancements on that third leg of the stool. This included the first ever press conferences by the Fed Chairman following FOMC policy releases, explicit inflation targets, and regular Fed governors’ forecasts. The FOMC also provided guidance on both the timing and trigger points it was following for the execution of the Federal Funds rate and its quantitative easing programs. These unprecedented actions provided a level of insight into Fed thinking that was previously unimaginable.

Ironically, however, those well-intentioned attempts at transparency may have inadvertently opened up the Fed to increased criticism. Last week’s unexpected hold on the Fed’s $85 billion per month asset purchasing program appeared to deviate sharply from the recent signals of Fed officials. In the eyes of most investors, the table had been laid for at least a modest reduction of stimulus. With external conditions at least somewhat stable, Wednesday’s decision seemed to toss away a perfect opportunity for this difficult process to begin.

In his press conference, Bernanke was asked specifically about the mixed signals the Fed was sending to investors. Bernanke responded, “Well, I don't recall stating that we would do any particular thing in this meeting. What we are going to do is the right thing for the economy. And our assessment of the data, since June, is that taken collectively, that it didn't quite meet the standard of satisfying our--or of ratifying or confirming our basic outlook for, again, increasing growth, improving labor markets in inflation moving back towards target. We try our best to communicate to markets--we'll continue to do that--but we can't let market expectations dictate our policy actions.”

This is true, and the Fed should not necessarily be blamed for the misinterpretation of signals by investors. Still, following a period that has largely been marked by Fed action in line with consensus, the shocking divergence has eroded market confidence. Subsequent to Wednesday’s surge, the market has slowly slid lower – not in volatile fashion, but in a steady downtrend. Shell-shocked investors appear to be questioning their handle on Fed policy and are shedding risk in response.

Fed governor Esther George acknowledged the damage done in comments on Friday. “The actions at this meeting, and the expectations that have been set relative to how markets were thinking about this, created confusion, created a disconnect.” She went on to note that the Fed will “have to think about the challenges that come with issues of credibility and the predictability of policy actions.”

As a rare hawk in the FOMC, George’s comments should be viewed in the context of her stance. However, her line of thinking does appear to parallel that of the broader investment community. While it may be a bit strong to suggest that the Fed lost its credibility at this point, the committee

certainly needs to work to rebuild the trust of financial markets following last week’s unexpected decision.

The Week Ahead

Several economic releases bear watching this week, including personal income and expenditures, new home sales, S&P/Case-Shiller Home Price Index, durable goods orders, and the third estimate of second quarter GDP.

The Federal Reserve will play an active public role this week, with 12 speeches being given by various members of the Fed. Given the lack of action last week, market participants will closely analyze every word in those speeches.

A handful of central banks will meet this week, including those in Hungary, Israel, Czech Republic, Taiwan, and Nigeria.

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