Chart of the day, Fed-tightening edition
This chart comes from Gavyn Davies’s excellent post on Fed tightening, which ought to be required reading for all members of the FOMC. He demonstrates the effect of the Fed’s tapering warnings in two ways: by showing that the expected short-term interest rate in mid-2016 is now about 100bp higher than it was at the beginning of May; and also, with the chart above, by showing that the market is now expecting rates to start rising much earlier than it had previously anticipated.
This chart isn’t, strictly, a tapering chart: it shows when people expect the Fed to start raising interest rates, rather than slowing down on QE. But that all-important first rate hike now has a 65% probability of taking place in 2014, according to the market — up from less than 15% in the NY Fed’s April survey.
Which raises the trillion-dollar question: given that the Fed hasn’t changed its messaging on rate hikes at all, what has caused this enormous change in expectations? Davies explains:
The markets have rationally taken the Fed statements on tapering as a signal that their thinking on monetary policy is changing. This signal of Fed intentions may be more powerful than the other forms of forward guidance they have given about their intentions.
There is evidence that this signalling effect of Fed balance sheet changes might be very powerful. If the Fed is not willing to “put its money where its mouth is” by buying bonds, then the market might take its promises to hold short rates at zero less seriously than before. According to this recent research by the San Francisco Fed, it is possible that a sizeable proportion of the total effect of QE on bond yields came from these signalling effects rather than the portfolio balance effects which have usually been emphasised by the central banks.
Put another way, you and I and Ben Bernanke might think that QE works because when you drop money from helicopters and that money is used to buy bonds and take them out of circulation, the price of those bonds goes up and their yield goes down. But in fact, the main reason that yields fell has nothing to do with the mechanistic consequences of buying bonds — as generations of investors have found out, buying up assets generally has only a very short-term and modest effect on the price of those assets.
Rather, QE turns out to be a surprisingly effective way of signalling to the market that rates are going to stay at zero for a very long time. And when you say that QE isn’t likely to stay in place much longer, the market takes that as tantamount to saying that rates are not going to stay at zero for nearly as long as they had thought.
Think about it this way: there is a nominal zero lower bound on rates. But there is a way for policymakers to be more accommodative than simply setting rates at zero: they can switch from “rates are at zero for the time being” to “rates will stay at zero for the foreseeable”. The markets don’t like taking words at face value, however: they want to see the Fed putting its money where its mouth is. As a result, when the Fed starts saying that it’s going to taper, the market sees rates rising again.
Fed officials are desperately making a concerted attempt to tell the markets that they’re wrong, but history tells us that when policymakers rail against the markets, the markets smell blood and often end up turning out to be right. The markets don’t care about “forward guidance”; they consider the Fed’s deeds to be more important than its words. As a result, so long as the Fed says that tapering is on the horizon, we’re never going to return to the interest rates we were seeing just a month or two ago.