Jawboning – as forward guidance used to be called – is both powerful and hazardous.  For investors and traders, ignoring the Fed is always a risky policy. So, forward guidance of lower interest rates will encourage a rapid market response to bring rates down towards the Fed’s desired levels.  But the Fed is not clairvoyant when it comes to predicting the economy or future policy needs. Sooner or later there will be a moment when the central bank will need to change its forward guidance, change from lower interest rates to higher interest rates.  In the days when watching the Fed was “watch what they do, not what they say,” a policy reversal was accepted, maybe even expected. But if forward guidance is cancelled and reversed, investors are likely to doubt or even ignore future forward guidance.  For now announcing intentions works, but for how long no one knows.

Currently the Fed pays interest on the reserves banks hold at the Fed.  Excess reserves – funds greater than the required level of banks’ reserves – rose sharply during the financial crisis when the Fed began to pay interest on reserves. Whether or to what extent the Fed can influence banks’ reserve positions through the interest rate it pays remains to be seen. However, this is one area that the Fed may look to if the needs of monetary policy shift.

What Next?

Expect a new economic forecast from the upcoming FOMC meeting.  If it is as optimistic as the last one or more so, say goodbye to QE123, expect more focus on the Fed funds rate and a little less interest in forward guidance. The transparency that Ben Bernanke brought won’t change.

About David Blitzer
David M. Blitzer is managing director and chairman of the Index Committee with overall responsibility for index security selection, as well as index analysis and management.

© S&P Dow Jones Indices LLC 2013. Indexology® is a trademark of S&P Dow Jones Indices LLC (SPDJI). S&P® is a trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a trademark of Dow Jones Trademark Holdings LLC, and those marks have been licensed to SPDJI. This material is reproduced with the prior written consent of SPDJI. For more information on SPDJI, visit http://www.spdji.com.

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