What game is the Fed playing? The Fed’s unconventional monetary policy so far has been a mix of Market policy (or, better, Balance Sheet policy) and Mouth policy. Indeed, great part of the job has been done “manipulating” expectations to make agents reacted to Fed stimuli the way it meant them to – or at least approach that way. Some commenters already noticed markets positioning on the impact of Fed policy rather than on fundamental proved to be a winning strategy.
Under rational expectations hypothesis, the only way for a policy change to have an effect on outcome is to be a policy surprise. That was exactly the point when Fed started QE: do something markets could not have already priced in. Now that it’s time to talk of “normalization” it is inevitable for the more cynic of us to wonder whether that same goal lies behind those fuzzy messages and open-ended formulas Fed uses. Are they trying to persuade markets that, quite abruptly, economy is recovering? Do they hope these expectations will be self-fulfilling?
On the one hand, the public version of the story: Fed wants to be as transparent as possible. All the continuous rebounds between tapering and loose monetary policy are the reflexes of the on-going decision-making process and the inexperience deriving from the very fact of venturing into unprecedented roads. Supporters already advanced the Fed is shifting to a ruled-based approach, the realm of predictability.
On the other hand, the more skeptical one: Fed strategy is that of launching a ballon d’essai to make markets move in the direction they want and, most of all, to launch many of these. Markets responses proved to be much faster that monetary authority imagined – Fed talks about medium term targets for Main Street, and Wall Street burns out these talks in one sole session. Most of all, they proved to be much stronger – they overreact, Lloyd Blankfein said. In this light the continue tiptoe on tapering is the sum of counterbalancing messages that aim at making markets react rather than overreact, as if Fed had to physically keep them on track. There is Bernanke saying the economy is going to be fine –hence the tapering– but still promising low rates; then Yellen, who hastens to specify real growth is the primary object and calm markets; then Bullars, who takes care of all those concerned of inflation dynamics.
All the fogginess surrounding times and conditions of a possible exit strategy just means Fed keeps some cartridge for the future. Nothing wrong with that. But the problem is: if Fed’s strategy hinges on manipulating expectation, what happens when markets get bored? Rational expectations cannot be systematically fooled and markets are too fast.
Something will happen for sure, sooner rather than later, but do not expect the Fed will come to tell you the whole story.
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