A self-contradictory communications strategy

Does loosening monetary policy mean lower or higher nominal interest rates?

An article in today's Financial Times  (H/T Brad DeLong) is a good illustration of the problems that arise when central banks frame monetary policy as a (conditional) time-path for nominal interest rates.

The Fed is trying to communicate two things. First, it is trying to communicate that it will buy long term bonds and this policy will be effective by pushing down yields on long term bonds, which should increase consumption and investment demand. Second, it is trying to communicate that this policy will be effective in increasing future inflation and real growth, both of which will push up yields on long term bonds. The Fed's "communications strategy" is self-contradictory. No single individual can believe both parts of that communications strategy at once.

“The Fed has been sending the message that its chequebook is ready and it will do what it takes to reflate the economy,” said Jan Loeys, head of global asset allocation at JPMorgan Chase. “What no one knows is whether inflation will start to show in two weeks or two years.”

Mr Loeys added: “We are seeing longer-term-thinking clients becoming increasingly wary of bonds and hedging against inflation. Shorter-term thinkers are still willing to buy bonds, on the presumption that they are nimble enough to get out when inflation comes to push yields up.”

Here's my take. There's one group of people who have ignored the first part of the Fed's message, and who are selling bonds. There's a second group of people who have ignored the second part of the message and are buying bonds. And each individual in the second group thinks he is quick enough to get back out before everyone else in the second group changes his mind and joins the first group. And they can't all get out before the others, of course.

What actually happens in the bond market depends on the relative size of the two groups, and how much wealth they are willing and able to bet on their beliefs. So the bond market cannot tell us whether the Fed's policy is working. We have to listen to people like Mr Loeys instead, who listens to the people actually trading in the bond market.

This is a bad way to manage a communications strategy. The Fed is telling the market it will push a policy lever down, that there is a transmission mechanism from this policy lever to the rest of the economy, and that pushing the policy lever down will pull the economy up. Unfortunately, there is another reverse transmission mechanism from the economy back to the policy lever, and if the economy pulls up, that will pull up the policy lever. So the market can't tell, just by looking at the policy lever, whether the Fed is really pushing it down, and if the transmission is working the way it is supposed to work.

It's as if some bad mechanic had hooked up the power steering the wrong way around. So if you wanted to turn right, you tried to turn the steering wheel left, at which point the power steering would kick in and force the steering wheel right overpowering your hands.

Expectations are more important than anything else in determining interest rates, output, and inflation. Those stupid bits of paper we call "money" would be worth nothing if people didn't expect them to be worth something. The whole purpose of central banks' having a communications strategy is to manage those expectations. You can't manage expectations with a self-contradictory message.

Here's an alternative communications strategy: "The Fed will loosen monetary policy by buying stocks; this will raise stock prices and make households more willing to consume and firms more willing to invest; this will increase aggregate demand and create a recovery. And, by the way, expectations of recovery will raise stock prices." That alternative communications strategy is internally consistent. Both parts of the message tell you that stock prices will rise. If it's credible, the Fed won't actually need to do anything, because stock prices will rise simply because expectations change. (Yes, I know the Fed maybe can't legally do this; but laws were made to be changed.)

And that's how the monetary policy transmission mechanism is supposed to work. The central bank tells people where it wants expectations to go, and expectations go there, and markets follow those expectations. All the central bank needs to actually do is make sure it doesn't subsequently do anything that would contradict those expectations, because that would harm its ability to manage expectations in future. The monetary policy transmission mechanism is not a set of mechanical levers. It's a communications strategy.

Comments

[RSJ]

ugh. If I borrow overnight and lend you for 4 weeks, that is exactly PEH. Sorry, I was wrong. Not even going to think about the other direction now.

[Doc Merlin]

"Yep. That's the exact case of helicopter money. It's what Australia did. But you can't subsequently reverse it, if you need to, without tax increases."

Sure you can, you can cut fiscal expenditures below a net of 0 and just delete the extra money.

[K]

FOMC QE2 statement is out.  Worth analyzing a bit.  Here's the part that's most relevant to this post:

"The Desk plans to distribute these purchases across the following eight maturity sectors based on the approximate weights below:  Nominal Coupon Securities by Maturity Range: 1 ½ to 2 ½ years: 5% 2 ½ to 4 years: 20% 4 to 5 ½ years: 20% 5 ½ to 7 years: 23% 7 to 10 years: 23% 10 to 17 years: 2% 17 to 30 years: 4% (The on-the-run 7-year note will be considered part of the 5 ½- to 7-year sector, and the on-the-run 10-year note will be considered part of the 7- to 10-year sector."

It's roughly equally distributed from 2.5 to 7 years.  Half as dense between 7 and 10 years, and almost nothing under 2.5 or longer than 10 years.  It's longer than I expected (I thought maybe 3-4 years for starters).  But if we ignore the part of the curve that they can't effect anyways (since it's already near zero) it's definitely skewed towards the shorter end of the curve.  And, to me, it looks like its having a (very small) effect in the intended direction.  On the announcement:  2 yr and 10 yr rates roughly unchanged.  5 year 7 bps tighter, and 30 year 8 bps wider. I.e. steepening from 5 to 30, cheapening the cost of funding for almost all purposes (less than 10 years is almost everything) and threatening inflation in the longer part of the curve.  So coherent practical and communication effects. 

On another note, by announcing exactly what they intend to do over the next 8 months, they just got front run.  You can't run a profitable trading strategy of that size in public.

[Nick Rowe]

K: Thanks for posting that.

Presumably, they wanted to be "front run". So the consequences start now (or rather, started when they first intimated they might do it).

You take the *steepening* of the yield curve, as opposed to the absolute level of yields, as evidence of the success of the strategy? The less than 10 years is where the actions are taking effect, and the greater than 10 years is where the communications strategy is taking effect?

[K]

Nick:

Yes, that's how I was thinking about it.  Though it's the 10 yr yield that's unchanged.  In terms forward rates, I haven't checked, but I would guess the forward curve (which is more like a short rate forecast) starts widening well before 10 years (6-7 years maybe?). 

Of course, it's both the steepening as well as the absolute move that's relevant.  But, for the most part, the overall size of the program appears to have been anticipated.  All we can really say from today's move is that the market appears to have been surprised that the duration of the purchases is going to be as short as they've announced.  Maybe that means that compared to the market, the Fed is leaning towards the perspective that it's best to principally manipulate the front end of the curve, and leave the market to handle the rest.  As I've said, I think that would be a sensible strategy, but 15 bps of steepening isn't huge evidence of anything.

[vjk]

K:

In terms forward rates, I haven't checked, but I would guess the forward curve (which is more like a short rate forecast)

Forward rates are implied and thus are nothing but pure speculation. They are useless for predicting short much less long rates. As the quantiest of quanty eared folks, Paul Wilmott, put it, assuming that interest rates follow forward rates is financial suicide.

[K]

vjk: Are you still on about the EH? I thought we were done with that.

[vjk]

Not at all.

Rather about predicting future with forward rates.

Although, I am sure, there was someone who tried to use forward rates to "prove" EH.

[K]

But forwards being the expectation of the short rate *is* the PEH.