Must-know: Dr. Stein explains alternative approach

Market Realist

Dr. Stein on monetary policy communication: Overview (Part 8 of 8)

(Continued from Part 7)

The alternative approach

While gradualism does a good job of meeting market expectations, it’s not an optimal solution because it prevents timely execution of harsh monetary policy decisions. An alternative approach, where the Fed can worry less about the immediate impact on the bond markets and can take aggressive policy decisions, sounds like an interesting hypothesis.

In Dr. Stein’s alternative approach, the markets expect the Fed to be less gradualist and implement harsh policy decisions without worrying about the short-term impact. This leads to market volatility between gradualist and alternative approaches. The alternative approach also provides the Fed with much needed flexibility to adjust the federal funds rate.

If the Fed can adopt the alternative approach, the change in prices of bonds and related bond ETFs such as the Vanguard Total Bond Market ETF (BND), the iShares 20+ year Treasury Bond (TLT), the iShares 3–7 year Treasury Bond (IEI), the iShares 7–10 year Treasury Bond (IEF), and the iShares iBoxx $ Invst Grade Crp Bond (LQD) will be the same as they would be in the gradualist approach.

While the alternative approach looks lucrative to policymakers, making a transition from the current gradualist approach to the alternative approach is a difficult task.

However, in his concluding remarks, Dr. Stein advocated for the alternative approach saying, “There is always a temptation for the central bank to speak in a whisper, because anything that gets said reverberates so loudly in markets. But the softer it talks, the more the market leans in to hear better and, thus, the more the whisper gets amplified. So, efforts to overly manage the market volatility associated with our communications may ultimately be self-defeating. As a result, the Fed should evaluate performance of its communication strategy on how transparent it has been and not on how they have achieved greater market stability.”

 

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