How the Fed keeps confusing the market

Handicapping the Fed's next policy move is looking more and more like a fool's game, even for those inside the central bank.

An institution that has come to prize itself for transparency suddenly has become opaque. Market participants wait on tenterhooks to figure out when or if another interest rate increase is ahead, but find themselves facing a confusing array of signals, none of which seem consistent and all of which are adding to market volatility.

Futures traders say one thing, economists say something else, and Fed officials — well, they're trying to find a relevant message using language that no longer seems to carry much meaning while appearing at least for now to be on a more aggressive course than Wall Street believes.

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The Federal Open Market Committee, after years of hesitation and a few false alarms, finally pulled the trigger in December and raised rates a quarter point, the first such move in more than nine years. Since then, though, it's been cacophony of market volatility aggravated by a lack of clear direction from the U.S. central bank.

Minutes from the most recent FOMC meeting in January did little to assuage market concerns. Fed officials themselves didn't seem to have a great handle on where policy is headed, with some form of "uncertain" appearing 24 times, which Gluskin Sheff economist David Rosenberg termed "by the far the highest tally in recent history."

The summary in part paints a picture of Fed officials frustrated by market reactions, at one point noting that "a couple of participants questioned whether some financial market participants fully appreciated that monetary policy is data dependent."

Rosenberg found the passage significant.

"The other notable comment from my lens," he said in his daily report for clients, "was the acknowledgement of divide between what the Fed is projecting in terms of the policy path and what the market is pricing in and how this represents a communications problem."

Central to the Fed's problem is not that it is "data dependent" but rather on what that means.

The Fed previously had used unemployment and inflation targets to service as policy triggers, but their utility has faded. The Fed waited until well past unemployment fell below 6 percent to enact the first hike, which came well before the FOMC meets its 2 percent inflation target. Thus, "data dependent" has morphed from a concrete set of benchmarks to a nebulous catchphrase.

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Citigroup economist William Lee called the January minutes "a study in stalling" and worried that the communication issue will feed market instability.

"Undoubtedly, there is increased policy uncertainty associated with the FOMC's market-dependent behavior," he said in a note he and his team sent to clients. "We are concerned that this feedback loop may amplify future market volatility and lead to a dynamically unstable equilibrium in the longer run."

Indeed, the Fed has seemed considerably more dependent on financial market gyrations that have shown an outsized reaction to a steadily mixed bag of economic data. U.S. stocks took a sharp turn lower after the December hike, while government bond yields have tumbled.

Amid the tumult, market participants have adjusted their expectations, despite the Fed officials' protests.

Futures traders now see no rate hike at least through February 2017, which has just a 39 percent chance, according to the CME's FedWatch tracker. Fed fund futures contracts indicate a hike is not fully priced in until October 2017. Those probabilities, however, were on the rise Thursday, even though Rosenberg deemed the minutes released Wednesday as "in a word, dovish."

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Wall Street economists also have been paring back their forecasts, though not as aggressively as traders. Many now expect no more than two hikes this year, contrasting with the four indicated in the most recent Fed "dot plot" chart of projections.

So even with the recent stock market rebound, confusion over Fed policy will serve as a negative in the "feedback loop" Lee cited.

"Such a potentially unstable feedback loop between markets and Fed policy behavior is likely the most important source of uncertainty going forward," he said.

"To [dampen] this feedback loop, we believe the FOMC will have to say more than the usual mantra that 'policy is data dependent,'" he added. "Something more concrete must be said about the size and kind of data and financial market developments that will be required to either continue or reverse its interest rate normalization policy."

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