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Fed Gov. Stein: Fed faces challenges in communicating.

"The market"--a conglomeration of people and institutions with varying opinions and goals--is not a single, rational person. And the Federal Open Market Committee (FOMC) must consider that reality as it communicates about monetary policy, Federal Reserve Governor Jeremy Stein said in a recent speech at New York University.

Stein said that before joining the Fed, he did not fully appreciate the complexities of communicating about monetary policy. One of the most important communications challenges involves the FOMC's "delicate interplay" with financial markets, Stein said. A critical part of that interplay is realizing that market prices reflect the interaction of many actors, not the beliefs of one actor.

Why did Treasury yields jump last year?

In making that point about the interplay of market actors, Stein cited a paper by economist Hyun Shin delivered at a Fed research conference last summer. Those interactions produced large movements in long-term Treasury yields in the spring of 2013, Stein recounted. Those moves were apparently in response to remarks then Fed Chairman Ben Bernanke made regarding the Fed's large-scale asset purchase program, or quantitative easing (QE).

But the market reaction seemed curious, Stein said. According to the Survey of Primary Dealers by the New York Fed, there was little change during this period--May and June 2013--in the expectation of the median respondent as to the ultimate scale of the asset purchases. Thus, Stein concluded, the FOMC communications were not apparently "meaningfully hawkish."

Then why did Treasury yields rise from about 1.6 percent to 2.7 percent in just two months? One theory holds that there was a wide divergence of views among market participants about the future of QE, Stein noted.

"In particular, however reasonable the median expectation, there were a number of 'QE-infinity' optimists who expected our purchases to go on for a very long time," Stein explained. "And, crucially, in asset markets, it is often the beliefs of the most optimistic investors--rather than those of the moderates--that drive prices, as they are the ones most willing to take large positions based on their beliefs."

"Very real limits" exist

Stein stressed that he did not think the communication during that time should have been different. "Rather" he continued, "the point is that in some circumstances there are very real limits to what even the most careful and deliberate communications strategy can do to temper market volatility. This is just the nature of the beast when dealing with speculative markets, and to suggest otherwise--to suggest that, say, 'good communication' alone can engineer a completely smooth exit from a period of extraordinary policy accommodation is to create an unrealistic expectation."

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Publication:Financial Update
Date:Apr 1, 2014
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