Don’t Presume ‘Forward Guidance’ Guides Fed Policy

Fed head Jerome Powell met the press Wednesday after a much-anticipated, two-day monetary policy meeting. Headlines treated it as a landmark event, but as usual, we don’t see what all the hullabaloo is about. Yes, yes, we know: The Fed allegedly has a new monetary policy framework that seeks an average 2% year-over-year inflation rate over some unspecified period of time using an unspecified calculation. Yes, we have seen the forecasts included in the release that hint at rates being near zero through 2023. But in our view, those taking these forecasts to the bank are committing a basic error: presuming that Fed policy is forecastable, even by those who set it. It isn’t, and trying to do so is a fallacy of the first order. Investors should tune out the noise.

First, to be clear, no actual policy change stemmed from this meeting. The fed-funds rate target range is still 0% – 0.25%. The bank is still vacuuming up long-term bonds under its wrongheaded quantitative easing program at the same pace as before, although it said (warned? threatened?) it could increase that pace. So the punditry hubbub mostly features the economic projections. You see, the Fed said it will remain accommodative for a really long time. Pundits argue its “forecasts” define a really long time as, “through 2023,” based on the Fed’s expectations inflation will be 2% (based on the headline personal consumption expenditures price index) and the unemployment rate will be 4% then.

Maybe that seems nice and tidy: Expect basically no return on cash and super-low rates for the next three-plus years, which lots of commentators are calling “powerful forward guidance.” In non-jargon, the Fed thinks talking about low rates sticking around longer is an extension of its policy aims. Since you won’t think rates are about to rise, the Fed believes you may behave differently than you otherwise might. The evidence for this theory is lacking, in our view. But that is what they say they think, and it is what many commentators commonly parrot.

What we are seeing few reference lately: Those “forecasted” unemployment and inflation rates aren’t actually forecasts. They are simply Federal Open Market Committee (FOMC) members’ expectations based on the information they have now. Consider: In December 2019, the FOMC expected the fed-funds range’s midpoint to end 2020 at 1.6% based on unemployment at 3.5% and inflation at 1.9%.^[i] Three months later they were cutting rates to near zero and unveiling a slew of other policy measures targeting COVID lockdowns’ fallout. In June, they projected unemployment would finish 2020 at 9.3%.^[ii] It was nearly a full percentage point under that in August.^[iii] Please understand: We aren’t taking them to task for erroneous forecasts. We are noting these aren’t forecasts in any understandable sense of the term. They are a policy tool; one that can and will change as economic data arrive—or as the biased interpretations of the humans looking at said data shift. Think of it this way: If the Fed’s forward guidance has its desired effect and spurs much more borrowing, lending and investing because people believe low rates are here to last, then the figures cited today will likely be wrong. Future guidance would probably have to change. Now, we don’t think forward guidance will have that or any identifiable impact, as the below-target inflation from the last eight years shows. This is merely us applying the Fed’s and pundits’ own theories to those projections.

Beyond this, there is another, simpler way to see that you can’t take this as a literal forecast of policy: We, umm, don’t know who will make policy over the next few years. Powell is up for reappointment in February 2022. Would either candidate running for the White House keep him? Unclear. Moreover: The FOMC sets policy by a vote. Typically, this body has 12 voting members: the 7 members of the Fed’s Board of Governors (including the Fed chair), the Federal Reserve Bank of New York’s president and 4 of the remaining 11 regional Fed bank presidents. Those four rotate annually.^[iv]

Currently, two of the seven Board of Governors’ posts are open. Another, Governor Richard Clarida, fills a term set to expire on January 31, 2022. Would Powell stay on at the Board of Governors if he isn’t reappointed as Fed chair? His predecessor didn’t. If that happens and Clarida isn’t reappointed, only three of the typical seven governors who voted on today’s policy announcement would still have a vote after February 2022.

Furthermore, the current FOMC includes the heads of the Philadelphia, Dallas, Minneapolis and Cleveland branches. None vote in 2021. Only Cleveland does in 2022. Even if the same Fed branch votes, the person voting could be different. Turnover at these positions isn’t uncommon.

Hence, presuming today’s projections write policy in stone through 2023 doesn’t account for how the FOMC works or the Fed’s history of changing its mind. It doesn’t account for all the economic twists and turns that can—and likely will—come in the next three years. Investors and pundits would do well to accept a simple maxim: You can’t know what the Fed will do in the future based on what it says today. All you can do is assess their actions and economic conditions as they occur.