Bond Markets: Fool Me Once...

By Michael Wallace What we have here, as Strother Martin memorably intoned in Cool Hand Luke, is a "failure to communicate." Ever since the Federal Reserve adopted a new approach to outlining inflation risks in its public announcements earlier this year, investors in U.S. Treasuries have voted with their feet. The result: A dramatic sell-off in bonds -- and a surge in interest rates.

How did the market -- and policymakers -- get in this mess? The seeds of the Fed's present communication gap were sown back in November, 2002, when Fed Governor Ben Bernanke's paper on modern deflation theory made declining prices Topic A for the Fed and the market. Even prior to that seminal speech, Fed researchers had tackled the topic of Japan's deflationary spiral and concluded that the U.S. was not in a similar bind, though prevention was the best cure. The central bank put the deflation issue front and center in its May 6 policy statement by separating its views on economic vs. inflation risks.

Unfortunately, more disclosure does not necessarily equate with greater clarity, as both sides are discovering. Indeed, market mavens are now arguing for greater simplicity over transparency, in the form of a one-dimensional inflation target rather than more information (see BW Online, 8/29/03, "Greenspan's Credibility Gap").

BEYOND CRUDE MEASURES. Chairman Alan Greenspan responded to this criticism in his speech Aug. 29 on "Monetary Policy under Uncertainty" at the Fed's annual summer symposium in Jackson Hole, Wyo. For starters, the Fed chief rejected a very short list of policymaking tools as simplistic. Compared to the complexity of the global economy, such crude measures would not be up to the task, considering even sophisticated models were often too linear and vulnerable to "large idiosyncratic shocks."

Instead, the Fed chief stated that he favored a "risk management" approach to policy that considers "not only the most likely future path for the economy but also the distribution of possible outcomes about that path."

In the end, Greenspan revealed what the critics suspected all along: Fed policy is a judgment call based upon a rational analysis of all the relevant factors. Greenspan clearly rejected being boxed in on policy options -- a move that's sure to frustrate those calling for more Fed transparency.

ON THE DEFENSIVE. The closest he came to addressing the current debate on policy was the acknowledgement that the Fed was inclined "toward policies that limit the risk of deflation though the baseline forecasts from most conventional models would not project such an event." As an example he cited the Russian debt default crisis of 1998, when the Fed cut rates "despite the perception that the [U.S.] economy was expanding at a satisfactory rate" -- an insurance move against a low-probability event of severe disruption to the domestic or international financial markets.

For all this openness, the Fed is likely to remain on the defensive on the topic of communication. At the Wyoming conference, the central bank's director of monetary affairs, Vincent Reinhart, tried to patch things up with the market. As the official in charge of drafting the Fed Open Market Committee statements, Reinhart said the markets and Fed should listen to each other more closely. He suggested that the 19 FOMC members not speak with one voice but offer their own opinions and that the Fed chairman's testimony should carry more weight.

Unfortunately for that theory, one of the largest jumps in bond yields -- and declines in bond prices -- came on the day of Greenspan's semiannual testimony before the Senate on July 15. After the miscues over deflation risks between the May and June FOMC meetings, the market was apparently in no mood to listen to Fed reason after the fact.

So don't be surprised if the market has little patience for the Fed's assurances that "policy accommodation can be maintained for a considerable period" in the face of a stronger-than-expected second-half economic recovery. Striving for more transparency has been one of Greenspan's biggest policy goals as Fed chairman, but at this point, he and his fellow policymakers may be better off heeding Mies van der Rohe's dictum that "less is more." The only thing that may quiet the Fed's critics now is fresh evidence of a strong -- and unambiguous -- economic upturn. Wallace is a senior market strategist for MMS International

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