The Fed’s Signal-To-Noise Ratio

October 29, 2009

Conflicting signals from Fed speak have central bank watchers back to playing the word game, adding renewed weight to every nuance that can be gleaned from official speeches and pronouncements. There is good reason for the mixed messages. Fed policymakers face a tricky task trying to ensure their commitment to an accommodative stance while also having to assure investors and the public that they will remove the punchbowl before the party gets out of hand.

Eric Lascelles at TD Securities applies a little physical mechanics to the study of Fed chatter.  

The contemplation of signal-to-noise ratios is usually the exclusive domain of electrical engineers. But this subject has become of increasing relevance to economists due to the sheer number of Fed Governors and Presidents who are now proffering their myriad views on a daily basis. It has become increasingly difficult to separate what constitutes a reliable signal of future monetary policy from the inconsequential noise. The monetary policy signal-to-noise ratio is currently very low. This partly explains why expected bond market volatility remains so high – central bankers as a collective are not offering anything close to a clear path forward.

Lascelles errs on the side of dovishness, telling his readers to focus on what Chairman Bernanke has to say.  “The TD view remains that the Fed will surprise many in how long it manages to remain on hold, with a first hike coming in Q1 2011.”

Recent press reports alluded to the possibility that the Fed might be pondering some shift in its language, either removing or moderating its vow to keep rates low for an “extended period.” But former Fed Governor Larry Meyer, now at Macroeconomic Advisors, says all the talk about a verbal baby step toward tightening is just that.

We see an implicit cost-benefit analysis taking place when it comes to considering any discussion on language. The benefits (added flexibility) are unclear, in that a subset of the Committee may feel that the current language is sufficiently vague that it does not stand in the way of an earlier tightening, if warranted by prevailing conditions. On the cost side of the ledger, some members will be very worried about an adverse market impact from dropping either the “extended period” or the “exceptionally low” terms. Taken together, these cost-benefit considerations would suggest somewhat reduced odds that language issues will be prominently discussed at this meeting and an extremely low probability that the language will be changed.

Does that mean that allusions to a rapid eventual exit, first floated by Fed Governor Kevin Warsh, are premature? Not if the Fed feels it needs to dampen inflation expectations, which would be understandable with today’s GDP report reading for the third quarter coming in at 3.5 percent.

Investors will undoubtedly stay tuned.

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