Macro Focus: Discretion over rules. The Federal Reserve’s “puzzle and conquer” strategy

Key takeaways

From its latest moves, it appears that the Federal Reserve has two important messages for the markets and for everyone else.

  1. Don’t fight the Fed: the first message is that market participants’ bets against the Fed are at their own risks and perils. By stepping up its support to the corporate bond market, beyond its purchases of bonds ETFs à la Black Rock and à la Vanguard, the Federal Reserve is signalling its intention not only of putting a back-stop on the markets but of using these purchases as al tool of monetary policy to provide additional stimulus to the economy, at a time when the fiscal agenda is clogged with bipartisan warfare and pre- electoral rivalry.
  2. Don’t expect any forward guidance from the Federal Reserve on its precise course of action over the next few months. The debate on forward guidance might be raging beneath the surface but the Fed has so far managed to keep a united face and to confine this debate to the inner circles of its monetary policy machinery.

These two seemingly contradictory messages are actually two facets of the same message: the Fed favours discretion over rules.

Detailed analysis

Don’t fight the Fed: The Federal Reserve as the price maker of last resort

As part of the Secondary Market Corporate Credit Facility (SMCCF) unveiled in April to which it already committed billions of dollars by buying shares in bond ETFs, the Federal Reserve announced that it will start buying individual US corporate bonds through a dedicated SPV, that would buy bonds based on a broad custom bond index,

The SMCCF facility is supported by a $25 billion capital injection by the US Treasury. If the capital allocation keys between this secondary market facility and the primary market facility are respected , the Fed could buy as much as $250 billion of outstanding corporate bonds over the next three months, before the initial projected end of the programme in September 2020.

The Federal Reserve signalled that it would adjust its plans if needed depending on a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. Arguably, markets were disappointed because they expected stronger forward guidance from the Fed, at a time when the prospect of additional fiscal support is far from granted.

Don’t expect any forward guidance from the FED amidst an uncertain macro outlook

The Fed announcement provided an instant boost to equity markets which were reeling from the Fed’s dovish tone and wait-and-see attitude displayed at the Fed’s latest FOMC meeting when it announced that it would continue its purchases of government bonds and government guaranteed securities at least at its current pace which amounts to $4 billion per week – or $20 billion per month – and that it would maintain the target range for the federal funds rate between 0 to 1/4 percent as long as necessary.

Economic Projections of the Federal Reserve Board and Federal Reserve Bank presidents, June 2020.

Central projections of the Federal Reserve Board for the US economy are aligned with projections made by other professional economists, independents institutes and industry bodies.

GDP Forecast
2020

2021
Unemployment
2020

2021
Federal Reserve Board (June 2020)-6.559.36.5
Survey of Professional Forecasters (May 2020)-5.63.110.88.1
The Conference Board (June 2020)-5.76.11110.8

However, one telling indicator of the high level of macro uncertainty the monetary institution has to deal with is the very wide range of 2020 GDP and unemployment projections made by the Federal Reserve Board members. The range for projected GDP growth in 2020 extends from -10.0 to -4.2. The range for the projected unemployment rate by the end of 2020 goes from 7.0 to 14.0 – a whopping 7 percentage points !

Source: Federal Reserve Board. June 10, 2020.

The alternative downside scenario constructed by the Conference Board is also another example of the prevailing uncertainty (cf. chart below). According to these projections and forecasts, the economic recovery can be anything from V-shaped to W-shaped or even L-shaped.

Rules versus Discretion revisited

The debate over rules versus discretion in monetary policy is as old as central banks and monetary policy itself. It can be traced back to at least two hundred years ago in Britain when the “Bullionist controversy” emerged in the troubled period of the Napoleonian Wars. At that time, Britain was under a maritime blocus imposed by France and the convertibility of gold to the sterling was suspended. According to David Laidler, ” the first approach associated in particular with Henry Thornton, recommended a degree of central bank discretion in dealing with crises, and the second, with important origins in the work of Ricardo, sought to cope with them by extending the legislated rules governing the monetary system beyond that requiring gold convertibility.” Hence, the rational for discretion was at that time and still remains today the need to provide sufficient flexibility to the central bank in order to manage the temporary shocks. Sticking to the rules – the gold standard parity for that matter – would only aggravate the impact of the shock as Henry Thornton wrote in 1802.

The idea that rules should be favoured over discretion came back in the XXth century under the writings of Milton Friedman whose explanation of the Great Depression put the blame on monetary policy errors that could have been avoided if the Federal Reserve had applied a rules-based policy. Friedman’s thesis found a favorable echo during the stagflation of the 1970s when inflation went out of control. The rational expectations hypothesis developed by Robert Lucas, Robert Barro and other neoclassical economists reinforced this attraction for rules, the Taylor rule being the favoured one. However in times of extreme uncertainty and potential macroeconomic dislocation the ideas developed by Henry Thornton make more sense than any mechanical rules. Hence, whether they like it or not the markets should get accustomed to the Fed’s “puzzle and conquer” strategy.

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