The Zieg-Fed Follies

The latest unemployment report came out last Friday, and as usual, it was a late confirmation of things markets already knew. One, the economy has grown—non-farm payrolls rose 288,000, beating expectations and knocking the unemployment rate down to 6.3%. Much of the punditry’s analysis stopped there, exploring whether this was good news (fewer unemployed!) or bad (shrinking workforce!)—a discrepancy we’d chalk up to the report’s wonky, survey-based methodology. In our view, though, a second takeaway is more compelling: It illustrates why investors shouldn’t put much stock in Fed forecasting or forward guidance.

In December 2012, the Fed started using a 6.5% unemployment rate as the threshold for considering a Fed funds rate hike—officially, an attempt to control market expectations for future policy moves and, anecdotally, an attempt to keep investors from freaking out over premature hiking. At the time, unemployment was 7.8%, growth was sluggish, and 6.5% seemed light years away. Fast forward to March 2014, however, and unemployment was down to 6.7% (for February)—a bit too close to the target—so the Fed scrapped it. To us, it seemed an implicit admission their earlier forecasting was too dour—they’d never planned to hike rates until well after quantitative easing was over, likely early 2016 at the earliest. The projections from the December 2012 meeting show most policymakers didn’t expect unemployment to meet the target until 2015 or later. The changed guidance amounted to a big “Oopsies.”

The Fed isn’t alone here. The UK did the same thing last year. When Mark Carney took over as Governor of the Bank of England (BoE), he brought the concept of forward guidance across the pond with him. In its first attempt, the BoE set a 7.0% unemployment rate as the threshold for considering a hike. At the time, unemployment was at 7.8%, and the Monetary Policy Committee expected it to hit 7.1% in Q1 2016. It got there last November, forcing some awkward backpedaling.

Now US unemployment is below the Fed’s former arbitrary threshold. On the one hand, this makes it abundantly clear why the Fed axed it. However unfounded, most believe rate hikes are an automatic negative. Imagine the commotion if the Fed hadn’t dropped that sentence! Even though it was merely a guidepost for kinda maybe thinking about possibly hiking rates at some point, many considered it an automatic trigger. The Fed would have had to eat crow and admit their forward guidance doesn’t mean anything or endure a firestorm of headlines berating them for opening the door to hiking rates too soon. Neither is a recipe for credibility. For central bankers, credibility is a must.

That’s one reason dropping the numerical target makes sense. Here is another: If broad labor market improvement is what you’re trying to measure, the unemployment rate alone is a terrible place to look. Now, we’d also quibble with the narrow focus on labor markets, but the Fed’s mandate requires them to seek maximum employment, so we’ll give them a pass. Yet the unemployment rate is a notoriously suspect statistic. It relies on data from the Household Survey only, which frequently differs from the Establishment survey. In the latest report, for example, the Establishment Survey showed 288,000 new jobs, yet the Household Survey showed a 733,000 drop in the number of people calling themselves unemployed. Which is right? We’d tend to find the survey with more universally understood guidelines and a larger sample size more valid, but the unemployment rate picks the other one. Using it as a guide would also make Fed policy dependent on wacky things, like how many people describe themselves as “actively seeking” jobs. Should monetary policy depend on folks’ job search habits? We don’t think so.

Now, by using a non-specific array of labor market and economic data, the Fed effectively gives itself permission to be more rational—a plus. Markets also have one less thing to try to game—another plus. Fed guidance was never supposed to be a blueprint for plans, despite the many assumptions to the contrary. After Ben Bernanke took the helm in 2006 with pledges to be more communicative than his predecessor, folks started believing the Fed should be transparent. And indeed, Bernanke did communicate more, adding more and more words to policy statements as his tenure progressed. But more words doesn’t mean more transparency—they’re as much an attempt at obfuscation as anything else. That’s historically what the Fed has sought. They know if they’re too clear, investors will try to front-run them, essentially backing them into a corner. If they end up defying those very firm market expectations, they lose credibility.

Investors, too, are better off without firm Fed guidance. Guidance or no, Fed decisions aren’t market functions. They’re decisions made by human beings, based on their very human (read: fallible) beliefs, assumptions and expectations. Trying to navigate them pre-emptively is pointless, in our view. Now, there is one less thing to tempt folks.