Federal Reserve policymakers have long watched markets to gauge what investors think is in store for interest rates and the economy. Some – like former Fed Governor Kevin Warsh – have worried that the Fed’s unprecedented purchases of trillions of dollars of U.S. Treasuries and its long-term guidance on the future path of interest rates shuts off a key source of policy-guiding information. The Fed’s recent decision to publish policymakers’ interest-rate forecasts will make the problem worse, he predicted in a speech at Stanford University last month.
In some sense I have partially been made blind by these asset purchases. I, for one, consider financial markets an incredibly useful source of information. If the markets take the Fed’s projections and build that into their own, then the Fed won’t have a full set of gauges in front of them. The markets will simply be a mirror to what they say.
Now comes San Francisco Fed President John Williams with a research paper that argues, to put it bluntly, that Warsh is wrong – that markets are providing just as much information about expectations for Fed policy as they did in the days before the Fed had bought $2.3 trillion in long-term securities and began signaling short-term rates would stay low for years.
In the working paper co-authored with San Francisco Fed economist Eric Swanson and quietly posted to the San Francisco Fed’s website on Monday, Williams argued that five-year and 10-year Treasuries traders still respond with as much vigor to economic news as they did before the financial crisis. As Williams explained to reporters after a speech Monday at Claremont McKenna College:
We continue to see the markets reacting to information — they still give a signal for what they are thinking about when the Fed’s going to do (what), what policy is going to be, what they think of the future path of the economy. The markets are still working, they are still digesting the information, and they are still responding to it.