Published June 14th 2022

Daily Brief - What is the Fed’s “forward guidance”?

50 or 75 bps? Equity investors are getting anxious about the upcoming Fed meeting. More than a few analysts think Fed Chairman Jerome Powell could surprise markets with a larger than anticipated rate increase of 0.75 percentage point. Meanwhile, others argue it’s unlikely the Central Bank would depart from the usual script: telegraphing its intentions far in advance.

The realization that interest rates must go a lot higher to cool inflation has been tough on equities. Federal Reserve officials have spent the past two months getting investors acclimatized to their plans to slow economic growth and combat inflation by raising interest rates in half-percentage-point increments until price pressures cool. A switch to 75 bps would definitely rattle that equilibrium. Why do it?

The case for a surprise

Friday’s inflation number was an unwelcome surprise to both policy makers and markets and diminished hopes for short term relief from rising rates. (For an excellent breakdown of inflation dynamics, we recommend this Barron’s article - unfortunately, paywalled.)

It would be an easy excuse for a surprise hike in order to signal the Fed’s firm intention to bring inflation to heel, even at the expense of economic expansion.

cpi june 13 2022

Forward guidance

But the surprise hike isn’t the only way to achieve this. The Fed has more tools at its disposal to signal a more aggressive posture towards inflation. In particular, they can raise borrowing costs for longer-dated loans by signaling a faster pace of hikes, or a higher ending point.

How does that work?

So far, the Fed has raised its benchmark rate by 75 bps this year. But because of the Fed’s signaling that there may be a lot more to come, the average 30-year mortgage rate has shot up by more than 2 percentage points, which is quickly cooling housing demand.

That means the tightening is showing up in long-term interest rates much quicker and is affecting the economy much quicker.

This type of communication - through speeches, statements, interviews - is called “forward guidance.” It has been important this year because investors have little recent experience with a Fed hiking cycle in an environment with such high inflation.

Forward guidance has been part of the Fed’s arsenal for most of the past two decades. When officials began raising rates in 2004, they hinted in their policy statements that increases would proceed in a manner that wouldn’t bulldoze markets, unlike the experience of a decade earlier, when the Fed raised rates sharply with no forewarning.

The end game

Mr. Powell faces two risks down the road: Go too slow or stop too soon and let inflation remain uncomfortably above the Fed’s 2% goal, or raise rates too much and push the economy into a sharp slowdown.

This calls for a nimbler tool than merely hiking the benchmark rate in surprisingly large increments. Markets would lose faith in the Fed that hiked for two meetings, then eased only to hike again at the following one.

Forward guidance, on the other hand, can be much more finely tuned. Get ready for a season of Fedspeak!

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Last week, Walmart heir Rob Walton bought the Denver Broncos in a record-breaking deal worth $58 billion.

walmart price june 15 2022

Daily Brief - What is the Fed’s “forward guidance”?

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