The Federal Reserve may have changed the way it moves markets without changing interest rates. Kevin Warsh went to Jackson Hole to tell financial markets to stop staring at the Federal Reserve.
He never explicitly called for a rate hike in September. Yet traders sharply increased their bets on one.
The probability of a September hike has climbed from roughly 36%, before Warsh's speech, to 66.4% on Tuesday, according to fed-funds futures from CMEFedWatch.
That is where an obscure monetary-policy idea involving the great soccer player Diego Maradona suddenly becomes relevant.
The Straight Line Behind the Goal of The Century
In May 2005, former Bank of England Governor Mervyn King delivered the Mais Lecture in London and referenced Maradona's second goal against England in the 1986 World Cup quarter-final in Mexico City.
Maradona beat five players over 60 yards. What King notes was that he did it running, in King's phrase, "virtually in a straight line."
The English defenders were not reacting to what Maradona did. They were reacting to what they expected him to do.
The idea was simple: sometimes the most powerful monetary policy move is the one a central bank never explicitly makes.
That is the mechanism. Market interest rates react to what the central bank is expected to do, so a credible central bank can steer the economy while barely touching its policy rate.
King called it the Maradona theory of interest rates.
King also named the opposite case. Maradona's first goal that afternoon, the Hand of God, stood in for the old mystery-and-mystique school of central banking.
Unexpected, time-inconsistent and against the rules.
The central bank does not reveal everything. Markets are forced to infer what policymakers might do.
That can create uncertainty. Uncertainty triggers volatility.
Warsh Keeps The Goal And Removes The Map
Warsh spent a long stretch of his Jackson Hole remarks dismantling forward guidance, the practice of telling markets in advance where policy is heading.
He said the practice "has overstayed its welcome."
He warned of a hall-of-mirrors problem, where the Fed reads market prices that are themselves only a reading of the Fed.
He said market participants should not look primarily to the central bank for their next trade.
What he did not touch was the destination.
He called the 2% goal, measured by the personal consumption expenditures price index — the inflation gauge the Fed actually targets — a firm, fixed target, and said price stability is not self-executing.
Then he gave his standard: the Fed must be confident inflation is moving to target "clearly and at sufficient speed."
Straight line. No map.
What The Defenders Did
Before Warsh's speech, futures priced in a near-35% chance of a September increase.
Within minutes of it, 55.7%. By Monday, 60.4%. By Tuesday morning, 66.4%, according to CME Group's FedWatch tool, which reads probabilities off 30-day federal funds futures, against 33.6% for no change.
The repricing showed up across assets.
The two-year Treasury yield rose about 8 basis points Friday to its highest since late July and the dollar index gained 0.6% to 99.66.
Gold – as tracked by the SPDR Gold Shares (GLD) – continued to fall, down 1.4% to $4,418.80 an ounce.
The S&P 500 — as tracked by SPDR S&P 500 ETF Trust (SPY) — closed 0.3% lower on Monday.
As of Tuesday morning, the two-year yield stood at 4.367%, the 10-year at 4.798%, and the 30-year at 5.287%. Long bonds took the harder hit. iShares 20+ Year Treasury Bond ETF (TLT) fell 0.8% to $82.21.
The Price Of No Map
King's straight line works because the defenders hold a stable view of where the player is going. Warsh has kept the destination and taken away the route.
That has a cost.
Strip out the reaction function and every inflation print becomes the reaction function.
Volatility is the word for a market that has to guess.
August payrolls land Friday, Sept. 4. August consumer price index data follows Friday, Sept. 11. The decision comes Wednesday, Sept. 16.
That meeting also carries a new dot plot, the chart showing where each policymaker expects rates to go. The chairman who says the Fed should not pre-commit is about to publish a page of pre-commitments.
If markets keep moving before the Fed does, the Maradona theory may be back in business.
The real question is whether Warsh is controlling expectations or simply making them harder to control.
