When Forward Guidance Fails
While The White House crows of the falling unemployment rate (which everyone now knows is entirely useless as an indicator of anything), the rapid-drop in this indicator is a major headache for the Fed. While forward-guidance is crucial in replacing the "common knowledge" that the Fed remains easier-for-longer as bond-buying is tapered, despite it's dismissal by vice-chair Stan Fischer and BoE's Carney (and even an almost admission of its weakness by Bernanke), Yellen faces a market that is betting massively (actually in record size) that short-term rates will rise and Fed heads like Lacker shift to "more qualitative ways" of maintaining the punchbowl.
The unemployment rate is meaningless (as we have shown numerous times but most recently here)...
So what happens when one renormalizes the unemployment rate calculation and uses a 30 year average labor force participation rate as a constant instead of a variable to be plugged by the BLS to goalseek a desired result? This happens:
What the chart above shows is that the "real" unemployment rate in October 2009 was 11.2%. Where is it now? 11.1%.
And there is your "Obama Recovery", when stripped of all the fancy veneer and TOTUSed propaganda, right there.
In contrast to his statements on QE, he has recently expressed a more skeptical view of forward guidance. Specifically, he noted in September that "if you give too much forward guidance you do take away flexibility," that "we don’t know what we’ll be doing a year from now. It’s a mistake to try and get too precise," and that "you can’t expect the Fed to spell out what it’s going to do…because it doesn’t know." These statements contrast with Yellen's strong endorsement of forward guidance. In that sense, Fischer's statements do pose at least some risk to our expectation that the FOMC will ultimately enhance its forward guidance by reducing the unemployment threshold to 6.0%.
Carney has hinted he favors spreading guidance over a broader range of indicators of slack in the labor market, focusing on the number of part-timers seeking fulltime work, hours worked and pay.
That may lead to a looser guidance framework that gives Monetary Policy Committee members more freedom than a policy based on thresholds. Forward guidance was introduced to provide clarity and contain investors’ rate expectations.
Six months after its introduction, it may have done the opposite.
Bernanke admits they were winging it and almost admits that forward guidance is just as unproven:
AHAMED: So, in devising QE and all these other unconventional monetary policies, were you pretty confident that the theory would work or that whatever you -- that -- going into it?
BERNANKE: Well, the problem with QE is that it works in practice, but it doesn't work in theory. That's...
AHAMED: Yeah. Right. (LAUGHTER) And the other way about forward guidance, probably.
BERNANKE: Right -- well, I -- I'm -- urrr
And now The Fed appears boxed into change... (and lose their own credibility)...
The rapid drop in U.S. unemployment will make re-crafting the Federal Reserve's easy-money promise a top priority for new Chair Janet Yellen, who will probably avoid tying policy to specific targets in the labor market.
It was more than a year ago that the U.S. central bank first promised not to raise interest rates until joblessness fell to at least 6.5 percent, a pledge that policymakers thought would hold until at least mid-2015.
The Fed still wants to assure investors that rates will stay low for at least another year, but there is growing debate among policymakers over how to get this message across now that the jobless rate stands at 6.6 percent but the pace of job creation remains erratic at best.
Fed officials are likely to drop any reference to a specific rate of unemployment, according to several who have addressed the topic in recent days.
"We will have to reformulate it and provide some qualitative way of providing an assessment of what time horizon we think is most likely," Jeffrey Lacker,
On the surface, the shift to a more qualitative, succinct message may seem modest.
But the stakes are high: policymakers are in the midst of phasing out their massive bond-buying program, but worry that the U.S. economic recovery could stall if financial conditions tighten too soon. To ensure that stimulus still flows, they plan to lean ever more heavily on their promise to investors that a rate hike is far in the future.
The trick for Yellen is rewriting this so-called forward guidance without suggesting the Fed is poised to drop its support for the economy, which could spark a spike in borrowing costs that stalls the slow recovery from the Great Recession.
"What you don't want is for markets to suddenly say, 'the economy is doing better,'" said Paul Ashworth, chief North American economist at Capital Economics, a research firm.
So Good news would be terrible news... for how will companies be able to finance their buybacks and dividends and M&A if rates were to rise?
and it seems that is exactly what the interest rate derivative market is betting on...
A short position in Eurodollars profits when implied yields rise, causing contract prices to fall.
[Simply put, Since July, the market has been betting in increasing size - now at record-size- that short-term rates will rise]
“The interest-rate derivative market is still very short,”, Jim Lee, head of U.S. derivative strategy at Royal Bank of Scotland Group Plc’s RBS Capital Markets in Stamford,Connecticut, said yesterday.
“So the path of most pain ahead is lower rates. These positions are likely to be squeezed out if rates fall further.”
A nascent unraveling of record derivative bets on higher interest rates may accelerate as turmoil in the world’s emerging markets and a tepid U.S. economic recovery sends bonds higher, according to RBS Capital.
So, The Fed is desparate to keep the world believing that they will be easier-for-longer but have lost any anchor of credibility for how to guide investors as to what that means without just an open-ended "we'll do it forever" meme. The market is betting the Fed will be unable to achieve lower for longer and is the most one-sided that rates will rise ever in history... which is why, if the EM crisis deepens or the slowing real economy glimpses its own shadow from a farce of weather-excused data, the max pain trade is a huge squeeze lower in rates.
As Bloomberg previously noted,
While there will probably be no major policy shifts in the January statement, investors will scrutinize the minutes when they are released on Feb. 20 to see if potential policy changes such as reducing the employment threshold to 6.5 percent or imposing an explicit inflation floor around 1.5 percent were debated.
Given the probable direction of the unemployment rate amid a structurally damaged labor market and disinflation, the Fed faces a dilemma in that the status quo is untenable and may soon be challenged by traders and investors eager to move back toward interest rate and policy normalization.
But the Bottom-line is that forward-guidance can only work if it is consistent and believable. The Fed has already begun jawboning to the extent that its previous forward guidance will change its structure and the most recent jobless data only reinforces the fallacy of unemployment rate thresholds. When the truth is the Fed 'has' to taper as the costs outweigh the benefits, and the replacement for QE is lower-rates-for-longer; a failed forward-guidance meme merely reinforces in the minds of investors the Japanification of the USA is complete.
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