The last time inflation was as high as it is now, in the 1980s, Paul Volcker was chairman of the Federal Reserve, and Ronald Reagan was president. There was no internet, no social media, no Twitter; sure, there was TV and radio; but for the most part, any decisions policymakers made on interest rates – the primary economic tool officials used to bring down inflation – would be read about the following day when the newspaper arrived, sometimes via the mail.
These days, the Fed is effectively telling traders about interest rate increases before they are even announced.
With soaring consumer prices again in the headlines as a national concern, Fed officials’ every word is disseminated and digested instantaneously and then priced into markets in real time. The resulting dynamic has increased not only the power of officials like the current Fed chairman, Jerome Powell, to affect markets from stocks to bonds to bitcoin – but also to draw instant scrutiny and feedback, with lots of second guessing.
For an example of how this works in practice, look at the sequence of events and news leading up to the Fed’s last rate hike earlier this month. On June 10 (a Friday), the consumer price index (CPI) – the most widely tracked inflation gauge – showed that inflation had unexpectedly accelerated in May to a new four-decade high.
The following Monday, the Wall Street Journal, known to be in close contact with Fed officials, reported that the U.S. central bank was considering a 75-basis point (0.75 percentage point) rate hike; previously, the officials had signaled that a 50-basis point increase was likely.
Shortly after the report, the CME Group's FedWatch Tool, which analyzes the probability of rate moves at upcoming meetings of the rate-setting Federal Open Markets Committee, showed that traders saw a 94% chance of a 75-basis point hike at the next meeting, up from 35% odds just one day before that.
“That was a little unusual because they got spooked by the May inflation number, so they wanted to do 75 basis points, and they wanted the markets to be prepared for it, so they leaked it,” said Steven Blitz, chief economist at TS Lombard, an economic forecasting firm.
Representatives from Dow Jones, owner of the Wall Street Journal, didn't immediately return a request for comment.
The Fed met for a two-day closed-door meeting on June 14-15 to discuss next steps. To no one’s surprise, the FOMC raised the fed-funds rate by 75 basis points.
During a press conference after the decision, the first question came at Powell: How did the rapid change of plans play out? He responded that it's important, now more than ever to “provide even more clarity than usual.”
“We got the CPI data and also some data on inflation expectations late last week, and we thought for a while, and we thought, 'Well, this is the appropriate thing to do,'" Powell elaborated. "So, then the question is, What do you do? And do you wait six weeks to do it at the next meeting? And I think the answer is, that’s not where we are with this. So we decided we needed to go ahead, and so we did.”
Powell has acknowledged that markets already know what the central bank’s next step will be.
“The forward rate curve is pricing in a rate path that looks a whole lot like the summary of economic projections that my colleagues and I submitted in June,” Powell said at a meeting at the European Central Bank forum on Wednesday. “That's the market understanding and finding credible what we're reading.”
The dynamic almost raises the question of whether the eventual rate hikes even matter. From the standpoint of markets, the impact of the Fed's pronouncements on future rate increases are already starting to affect the economy.
The Atlanta Federal Reserve is now forecasting a 1% slowdown in gross domestic product in the second quarter. Given that GDP fell by 1.4% in the first quarter, that would mean that the U.S. economy might already be in a recession. Mortgage rates have also soared and are already hitting the housing market.
During a testimony in front of lawmakers earlier this month, Powell said: “Financial conditions have already priced in additional rate increases, but we need to go ahead and have them.”
‘Forward guidance’ by the Fed is not new, but different
This “forward guidance” stance by the Fed isn't new. Ben Bernanke, who served as Fed chairman from 2006 to 2014, said at a Brookings Institution event last month that “monetary policy is 98% talk and 2% action.”
But the Fed’s forward guidance under Powell is very different from Bernanke’s Fed, which left room to maneuver in case of unpredicted economic circumstances – or unexpected data like the worse-than-expected inflation report in May, which caused the Fed to change its original rate hike plan.
“I think it has backfired a little bit because it tends to tie their hands, and so you ended up with this embarrassing situation a few weeks ago where they told everybody 50 and then at the last minute they made it 75,” said David Wessel, a senior fellow in economic studies at the Brookings Institution and former Wall Street Journal economics editor.
Today’s Fed is much more specific
“I think it is a matter of emphasis," said John Silvia, former chief economist for Wells Fargo and founder of Dynamic Economic Strategy. "Both guidance and interest rates moves have been in vogue since Bernanke, but the forward guidance really came through with Powell.”
During the Bernanke era, this new transparency by the central bank came with controversy among traders who believed that it weakened the effectiveness of the tightening if the system isn’t shocked.
The communication philosophy changed “from a view that central banks are more powerful when they surprise the markets to central banks are more powerful when they explain to the markets what they're thinking,” Wessel said.
“They say we’re thinking about doing 50 basis points at each of the next two meetings, that specificity is different,” he added.
This new level of transparency is also likely a result of the Fed wanting to protect today’s volatile markets, which are already suffering from macroeconomic uncertainty, which means that traders have to watch every word the Fed is saying, because “they do get the tightening without actually having to raise rates,” Blitz of TS Lombard said.
Because bitcoin is now trading in sync with traditional markets, all this means that crypto traders are now hanging on every word that drips from the mouths of Fed officials.
“We pay close attention to some of the major proxies that the Fed uses to signal prior to meetings,” said Joshua Lim, head of derivatives at Genesis Global Trading, a crypto firm. “In particular, they seem to favor the economics correspondent at the Wall Street Journal to communicate their intentions and reasoning to the market.” (Genesis and CoinDesk are both owned by Digital Currency Group.)
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