Mike Dolan

LONDON (Reuters). – The U.S. Federal Reserve is changing its plans week by week. This means that the idea of “forward guidance”, as a tool for policy, has been effectively abandoned.

This year’s latest financial market earthquake is an example of one of three key monetary policy levers being abandoned out of necessity or, most likely, because of choice.

On March 4, Fed Chief Jerome Powell said that a 75-basis-point increase in interest rates was not an option the central banks policy committee considered. This was three months before it announced to journalists that an “inordinate” rate of 75 basis point was part of its plans for rate increases to reduce 40 year high U.S. Inflation.

Markets feel that they were pushed to the end by the Fed. This is after an unusual series of events, which followed Friday’s unexpected acceleration of consumer price inflation.

Although the inflation numbers did a little to shake bond and interest rates markets, Fed officials remained in their pre-meeting “purdah”.

All hell broke loose Monday when Nick Timiraos, Wall Street Journal Fed watcher, reported that Powell and Co. would actually “consider” moving 0.75% this Week – contrary what he had written at the weekend.

Fixed income was exhausted and had to be repriced to reflect a completely new Fed trajectory. It would take the Fed from a low of around 4% this week up to peak levels of around 4% in March. The dollar soared and stock markets fell around the world.

Jan Hatzius, Goldman Sachs’ (NYSE:), economist instantly modified the bank’s prediction to expect a 75bp Fed rate move this week and next. He cited the WSJ article for the “hint” from Fed leadership and Friday’s inflation print.

No matter what the result, this last-minute guessing game, and jumpy decision-making – even if the Fed was involved – are a marked departure from decades of forward guidance that has been designed to not shock markets and increase transparency, and to allow investors to take in changes to policy direction for months, if not years.

Investors should be aware that Fed and other central bank deliberations will likely become less predictable in the months ahead. This could lead to greater volatility and uncertainty, which will result in higher risk premia.

Both short- and long-term U.S. Treasury Yields surged past 3% on Monday. With the recession warning in the 2-10 year yield curve inverted yet again, MOVE index to Treasury Volatility saw its greatest one-day leap since March 2020. This was when the pandemic erupted and is now at its highest point since 2009.

As the Fed continues to unwind its massive bond balance, the “term premium”, still negative to investors and implying that they do not demand additional compensation to hold long-term debts to maturity, could be the last to go.

GRAPHIC: Yield Curve Inverts as Implied Fed Rates Peak Hits 4% (https://fingfx.thomsonreuters.com/gfx/mkt/akpezlgbjvr/Two.PNG)

GRAPHIC: US bond volatility, yields and term premium (https://fingfx.thomsonreuters.com/gfx/mkt/zgvomdwozvd/One.PNG)

‘OVER-TIGHTENING’

Many are now apprehensive about the Fed’s new economic forecasts this week. The old expression “data dependent” is being used again.

This is normal. However, some extreme economic distortions caused by the pandemic reboot in Ukraine and the war in Ukraine as well as the uncertainties surrounding energy prices and fuel prices could cause some unexpected recalibrations. This is likely to lead to wild changes that will affect how the Fed or other central banks think from month to month.

Thomas Costerg, Pictet Wealth Management’s CEO, believes that the Fed’s response function is now “backward-looking”, has panicked over past high inflation levels and is prone to political pressure.

Allison Boxer from Pimco, an economist thinks that 75bps will be possible this week. Boxer believes the Fed would continue to hike beyond September, creating a risk of excessive tightening.

Many economists have criticized “forward guidance” as being too far into the future. This is why central banks and the Fed were slow to adjust interest rates after the recovery of the economy from the pandemic. You might need to store it for a while.

The quasi-formal instrument of policy, forward guidance has been codified only in the last 15-20 years to allow central banks another means for them to influence long-term borrowing rate and market expectations. This was mostly during the decade that key rates were at or near zero but deflation still lurked. As a way to maintain traction at long-term rates, it was used in conjunction with bond buying.

In the 1990’s, this was still true. It was not only a close-knit Fed that played all its cards, but it also took over 24 hours to go through the runnings of open market operations in order to find out whether policy had changed.

Keep them guessing is a common mantra around the globe. German Bundesbank insiders used to advise telling the markets how they formulate policy, but not what they are planning to do tomorrow.

The deflation and other “zero lower bound problems” of the previous decade are gone, so guiding the markets in interest rate hikes is an almost new endeavor.

Yet, the Fed’s forward guidance in the first years of tightening was blamed for suppressing volatility. They also sparked excessive risk taking which led to the crash of 2007/2008.

Do they need to guide on the long rate but not on policy shifts?

The Fed could see some compromise between these two in order to navigate a bumpy ride.

The author serves as editor-atlarge at Reuters News for markets and finance. These views are solely his.

(by Mike Dolan. Tweet (NYSE:): @reutersMikeD. Jane Merriman Editing