The Dallas Fed’s Richard Fisher at the Asia Society
Fisher spoke at the Asia Society in Hong Kong on Friday, April 4, about “forward guidance” in monetary policy, which he described as “the subject du jour of central bankers.” It recently became a focus of discussion again in the U.S. after the Fed’s March FOMC meeting, when the Fed decided to go with “qualitative” rather than “quantitative” guidance regarding its future monetary policy statements. During his address, Fisher also spoke about the types of forward guidance that central banks could give: Odyssean (clear-cut quantitative goal posts) or Delphic (qualitative without contingent commitments to specific goals).
Why is the timing of the base rate increase so vital to markets?
According to Fisher, quantitative easing (or QE), by taking the volatility out of markets, has not only enabled debt-laden consumers, homeowners, and corporate treasurers, but has also made the life of money market managers a lot easier, as the base rate has been near 0% since December 2008. The low interest rate environment has translated across the credit and maturity spectrum, enabling the “run up the price of stocks and bonds mostly in straight-line fashion, and it has taken volatility out of the marketplace, allowing market operators and their clients to profit with little effort.”
So market participants would definitely prefer clear-cut goal-oriented guidance (Odyssean) since it enables them to keep profiting from a low-volatility environment.
The S&P 500 Index (SPY) breaches new records
The S&P 500 Index (SPY) increased to 1,885.52 on April 3, 2014, beating its previous record reached on March 7, 2014, on Janet Yellen’s dovish March 31 speech, as well as due to favorable PMI readings from the manufacturing sector. The index also reached an all-time intraday high of 1,885.84. This was after the Index (SPY) had already clocked returns in excess of 15% in 2012 and 32% in 2013.
According to Richard Fisher, stocks and bonds have been bolstered by the Fed’s easy monetary policy in recent years. One ETF providing exposure to the S&P 500 Index is the State Street SPDR S&P 500 ETF (SPY). The top holdings in SPY include banking behemoths JP Morgan (JPM) and Wells Fargo (WFC).
Fixed income investors, too, have gained from the low rates. Two ETFs investing in high-yield debt, the SPDR Barclays Capital High Yield Bond ETF (JNK) and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), have clocked total returns of over ~26% over the past three years (to March 31, 2014).
Understanding the “Odyssean” form of forward guidance
Odyssean guidance is a forward guidance technique used by central bankers that uses a specific policy rule or criterion to choose between different policies. Central bankers hope to achieve superior long-term outcomes by sacrificing short-term freedom of action through Odyssean guidance. Theoretically, clear-cut monetary policy guidance, represented by the Odyssean method, would reduce recessionary risk in the economy and tightly control medium-term inflation expectations at the cost of “a somewhat poorer near-term inflation or unemployment performance,” Fisher.
To learn more of what Fisher had to say about Odyssean and Delphic forward guidance, please read on to Part 7 of this series.