Back to the Future

March 20, 2014

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Fed Chair Janet Yellen held her inaugural post-FOMC-meeting press conference [yesterday] and turned in a virtuoso performance. She began reading a long explanatory statement that, given the detail and lengthy elaboration of key issues, had to have been drafted long before the FOMC meeting itself.

But it was during the Q&A that she really shined. She was both relaxed and confident. Furthermore, she demonstrated a deep, almost encyclopedic, and nuanced view of both the current economic situation and financial markets. Speaking as the Fed chair, she was particularly forthcoming in a way that suggests that the FOMC will be even more open than it was during her predecessor’s tenure. She painstakingly indicated that once the asset tapering process was completed, any movement in or abandonment of the FOMC’s zero interest rate policy would not be driven by or tied to an unemployment-rate trigger, but would depend upon a wide but eminently reasonable range of data on both the real economy and the employment situation. As a result, however, the audience was left with little in the way of concrete indicators that would in any way provide meaningful forward guidance about the likely course of policy. It was a “back to the future” moment that recalled the Bernanke Fed’s repeatedly emphasizing that policy was contingent upon incoming data.

The rhetoric of forward guidance indicating that policy is contingent upon future data points out the contradiction between theory and practice when it comes to communications and forward guidance. The economic theories and models that guide much of the Fed’s thinking about policy, such as the new Keynesian models of Michael Woodford and others, imply that communications and forward guidance can be important tools in shaping expectations and thereby improve economic outcomes. In such models, however, forward guidance isn’t “just words;” instead it typically points to single indicators whose values condition policy that will be credibly followed by policy makers. Fed research papers continually use policy rules, like the Taylor rule, that are assumed to be known by market participants and that depend upon only one or two data series. The Taylor rule, which of course has many variants, describes how the short-run nominal interest rate should be set as a known function of the so-called output gap (the difference between where the real economy is and where it would be at full employment) and where the inflation rate is relative to the target.

But the real world is more complex than the models are, and many factors can and should come into play that can shape policy makers’ decisions. Because of those complexities, policy makers are reluctant to commit to a rule, and instead seek to preserve discretion. Discretion in this case means the option not to follow the rule when facts dictate otherwise. But preserving discretion also means that it isn’t possible to provide the kinds of precise guidance that theory demands, and this tends to undermine the kind of credibility the models demand. This is a long-winded way of explaining why the FOMC has backtracked from a communications strategy that employed a single number, such as using the unemployment rate as a policy trigger. The real world doesn’t fit the models.

Chair Yellen did make one misstep that markets picked up on immediately, and that occurred when she indicated that a policy move might come as soon as six months after tapering had ended. This would put the upward move in interest rates sometime slightly before or by mid-year 2015. She went on to carefully point out that the six-month time frame was contingent upon forecasts being realized, but markets heard only “six months.”

All in all, however, this first Yellen press conference contained few surprises and did serve to reinforce that a competent policy marker is in charge and that abrupt changes should not be expected when it comes to how business is conducted under this new regime. The Fed continues to muddle along with its non-forward-guidance guidance, which implies continued and perhaps increased volatility on the margin. Moreover, it implies that even more attention will be paid to speeches and utterances of FOMC participants going forward.


The preceding is a commentary by Bob Eisenbeis of Cumberland Advisors and has been reposted with permission of the author. View all Cumberland Advisors’ commentaries at


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