The biggest challenge for the Federal Reserve over the next two years is “to manage market expectations for interest rates,” according to a report issued by Merrill Lynch on Thursday. “It is safe to say that many bond investors are confused and frustrated by the Fed communication,” it noted.
What’s behind the confusion and what exactly is needed to guide the markets in a rising-rate environment after last summer’s tapering drama? The Merrill experts lay out exactly what happened and what needs to change.
They also draw a clear conclusion on the level of clarity the Fed has been sharing of late, which should be good news for investors and advisors seeking less volatility in both the fixed-income and equity markets.
“The Fed has had a tough time communicating its policy intentions,” Ethan Harris and several other economists explained. “At the start of last summer, tapering talk caused a sharp sell-off in the bond market. A few months later, the Fed surprised the markets by not tapering.”
In recent months, there’s been confusion around how to interpret the “dot plot,” which shows forecasts by various members of the Fed Open Market Committee of how high the federal funds rate will be at different times in the future, and whether there is a “six-month rule” for interest-rate hikes, the economists say.
The confusion, the Merrill experts say, stems from the “uncharted territory” of both a weak recovery and the use of “unconventional policy.”
The Fed also suffers from a “very awkward communication structure.”
In contrast, Norway’s central bank, which has used forward guidance for a decade, employs a simple and transparent process. “With just seven members, the committee is small enough to be efficient and big enough to get a diversity of views,” the report explained.
“These published forecasts, including the interest-rate projection, are derived from a consistent set of underlying assumptions,” it added. “By contrast, the Fed has a very awkward structure.”
Indeed. The FOMC has 19 members and 11 regional presidents, including four voting positions that rotate each year. It also has 13 different research groups.
“The official forecasts are not derived from a careful discussion with consistent assumptions, but are delivered by spreadsheet without a systematic discussion,” the economists explained.
The group relied on different and inconsistent means of communication.
“In our view, all of this means lots of head fakes for the markets and headaches for investors,” the Merrill analysts said.