Yellen faces her biggest test after years of Fed coddling markets

September 23, 2015

A trader works underneath a television screen showing Federal Reserve Chair Janet Yellen announcing that the Federal Reserve will leave interest rates unchanged on the floor of the New York Stock ExchangeThey say every top central banker faces a “test,” and this may be it for Federal Reserve Chair Janet Yellen.

Paul Volcker needed convince skeptical Americans he was dead serious about slaying inflation in the late ‘1970s and early ’80s; Alan Greenspan calmed the 1987 stock market crash by pledging as much Fed liquidity as needed; and Ben Bernanke, of course, unleashed novel and unprecedented policy stimulus in the face of the worst recession in decades. Yellen, who took the U.S. central bank’s reins early last year, has since managed to wind down some of that stimulus while quietly untangling the Fed from many of the Bernanke-era promises of near-zero interest rates for a long while to come. So far she’s had a pretty smooth ride. But now that she is looking to pull off the first rate hike in nearly a decade, investors, economists, and even former U.S. policymakers are howling about a lack of clear guidance on when it will actually happen.

Perhaps oddly, it was last week’s decision to delay a rate hike – a decision that financial markets largely predicted – that set off the firestorm of criticism over muddled Fed communication. While the U.S. economy appears ready for a modest tightening, the Fed and Yellen highlighted recent financial market turmoil, uncertainty over global growth, and renewed downward pressure on U.S. inflation as reasons to stand pat. The Fed would remain “data-dependent” as it seeks stronger assurance that both inflation and the labor market are headed in the right direction, Yellen said in a cautious-sounding press conference. Notably, she refused to make any specific promises on what exactly would prompt the central bank to finally act.

Well, for a world hooked on easy Fed money and obsessed with the timing of U.S. rates “liftoff,” that didn’t go down very well. The complaints ranged from the Fed letting markets dictate monetary policy, to the central bank losing its nerve, to the conflicting messages from a handful of Fed policymakers who have since spoken publicly.

Here‘s former Dallas Fed President Richard Fisher, on TV on Tuesday: “I don’t think I’ve seen this much confusion in my ten years of service… It is really not a good signal, I think it has discomforted the markets, and I hope they find a way to correct the image they have created that they are lacking in direction, and give a sense of where things might go.” Others said Yellen would be wise to use a Thursday evening speech to clarify things for financial markets that, in the absence of certainty, have discounted a rate hike until early next year.

Enter John Williams, president of the San Francisco Fed and Yellen’s former right hand man when she had the job there. Chatting with journalists in Armonk, NY, last weekend, he faced several questions over communication. His message? The Fed needs to stop coddling the world, and the world needs to start walking on its own, now that things are getting back to normal:

“Our goal is not to have participants in financial markets like us for our communications. Our goal is to communicate our thinking around our strategies and policies as effectively as we can given the uncertainties and … our decision-making structure.” “Strong” cases can be made for and against liftoff, he said, “so it’s appropriate that we don’t signal to the public (that) we’ve decided what we’ll do before we’ve had that conversation … and come to a committee decision.”

“That may be uncomfortable for people because we have in the past been much more directive about our policy views … with forward guidance. But given where we are today, the decisions we need to make, I think it is appropriate that we are explaining as I do the considerations that go into a decision, and how we are approaching it – but not saying before a meeting that this is what we’re going to do, so now you know.”

“I don’t worry about the markets thinking, ‘Well I didn’t expect that,’ and the probabilities going into it being different,” he said, adding people need to “get some of that muscle memory” back about the Fed’s reaction function to economic data.

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