Fed reveals weak spot in superhero powers

September 20, 2013 5:18 pm

Fed reveals weak spot in superhero powers

By Ralph Atkins in London and Michael MacKenzie in New York

Superman had issues with Kryptonite. For Achilles, it was his heel. With central bankers, is it communicating with markets? The US Federal Reserve startled investors round the globe this week by deciding not to start scaling back its $85bn a month of asset purchases, or quantitative easing. Bond and share prices jumped sharply on the prospect of unexpectedly undiminished Fed largesse. But even as they pocketed gains, investors wondered if they had misunderstood Ben Bernanke, Fed chairman. Based on hints dropped since May, the consensus view had been for a $10bn to $15bn reduction in the pace of purchases.Central banks have sought to increase the effectiveness of their communication during the years of financial crisis. By extending their influence over markets’ expectations of future interest rates, they hope to leverage their superhero powers. But the Fed’s last minute hesitation was a reality check.

“It does raise the question of whether markets will believe the Fed in the future as much as they have in the past,” says Huw Pill, head of European economics at Goldman Sachs. “Why bother with transparency when you can – and do – change your mind,” asks Tom Di Galoma, co-head of rates trading at ED&F Man.

US 10-year Treasury yields, which had hit 3 per cent earlier this month, fell below 2.7 per cent after the Fed’s announcement. The FTSE All-World share index ended the week up more than 2 per cent, while the US S&P 500 reached a fresh record on Thursday.

“It is not so much an Achilles heel but the fact is that the Fed is really driving market prices – and so even subtle shifts in the way the Fed is appraising the situation can make a big difference,” says Julian Callow, international economist at Barclays.

The communication challenge facing central banks has escalated because of the massive expansion of unconventional monetary policies. “We’re dealing with tools that are less familiar, harder to quantify, and harder to communicate about than the traditional funds rate,” Mr Bernanke admitted at his press conference on Wednesday.

His experience is being watched closely in Europe, where the European Central Bank and Bank of England are experimenting with “forward guidance” to persuade markets that interest rates will remain low – with mixed results so far.

“In the distant past, it was just about rate-setting for given economic conditions,” says Steven Major, head of fixed income research at HSBC. “Now central banks are giving forward guidance on interest rates for the next few years, and they are using their balance sheets to influence the yield curve . . . They are setting interest rates from overnight out to 10 years and more.”

The danger is that central banks end up bewildering markets by over-complicating their message. The Fed’s argument that “tapering” asset purchases did not amount to a policy tightening “proved too convoluted to overcome”, says Richard Gilhooly, strategist at TD Securities.

A survey by Barclays, published just days before the Fed’s meeting, showed financial market experts’ rating of central banks’ communication skills had fallen particularly sharply over the past few years for the ECB. One explanation is that news about splits on its governing council often leak, confusing markets. In the US the Fed has had a reputation for relatively little dissent. “Maybe the [US] Federal Open Market Committee is becoming a bit more like the governing council in Frankfurt – you are less sure about what is going to come out at the end of the meeting,” says Mr Pill, a former ECB official.

But not everybody is blaming the Fed. Mr Bernanke had linked its decision to the strength of the economy – and the data had weakened, points out Mr Major. “Market opinion tends to crowd around a consensus without much original analysis – nobody seems to be listening or thinking,” he says.

Jim Reid, Deutsche Bank strategist, admitted in a note: “All of us are guilty of herd mentality as very few analysts deviated from the $10-15bn tapering estimate in their forecasts.”

Investors may also have overestimated their importance in the eyes of central banks. Their targets are inflation and job creation – not profits for portfolio managers. “The markets only matter to the Fed’s monetary policy stance insofar as they affect the real economy. That is something people in the markets tend to overlook,” says Mark Cliffe, chief economist at ING.

The Fed’s communication headaches may only get worse as it continues to debate how to wind down QE and a decision nears on a successor to Mr Bernanke. Janet Yellen, Fed vice-chairman and current favourite to take over, may provide the next big test when she speaks to the Economic Club of New York in early October.

This week’s Fed’s decision ranked as the biggest shock for the market since the emergency rate cuts made in 1998, when Long Term Capital Management collapsed, according to John Brady, a managing director at RJ O’Brien. “Yellen will have an opportunity to define the Fed’s policy and we will see how the 10-year Treasury yield reacts to that message.” Can Superwoman do any better?