Forward guidance:  Parallels from the end of 2000

From: Bill Nelson <Bill.Nelson@BPI.com >

Sent: Friday, December 1, 2023 7:18 AM

Subject: Forward guidance: Parallels from the end of 2000

I only write these emails when I think that I have something useful to say that isn’t also being said by everyone else.  It’s been over a month since my last one (past emails are archived here ).  The Fed is not giving me any material.  Policy is well placed, and communications have been about right. 

There is a modest tension in current FOMC communications.  Clearly, even though the September dot plot included one more 25 basis point increase in 2023, the Committee is going to leave its target range for the funds rate unchanged in December.  And yet, even though their baseline outlook involves cutting rates a bit next year, they seem understandably worried that if they communicate that they are done tightening, markets will focus exclusively on cuts.  To push back, they are mostly emphasizing that interest rates could be increased further rather than that there are two-sided risks.  While I think the market is not putting enough weight on the possibility that interest rates will be increased further, the interesting question is whether the slightly disingenuous tightening bias and Chair Powell’s desire not to be Aurthur Burns (and cut too soon) will result in the Committee cutting too late if economic developments call for an easing.  If so, any easing, if warranted, could be rapid.

There are some striking parallels between the current situation and the FOMC’s deliberations and actions at the end of 2000.  At the November 2000 meeting, the Committee indicated that the risks were tilted toward higher inflation (a tightening bias).  At the December meeting, they switched to risks tilted toward weaker growth (an easing bias), skipping balanced risks.  Just a few weeks later, at an unscheduled meeting in early January, they cut 50 basis points.  They cut 50 bp again at the scheduled January meeting and cut rates at every subsequent meeting in 2001.  Over the year, they cut the target by 4¼ percentage points.

At the November 2000 meeting, Chairman Greenspan argued in favor of retaining the tightening bias in part because a shift to balanced risk would result in an unwanted easing of financial conditions: 

…even if we believe that the risks are truly balanced as of today, the market doesn't believe that is our view. As a consequence, were we to go to balance today we would almost surely end up tomorrow with financial conditions that would be too easy in terms of the current outlook. (transcript pp. 85-86)

At the December 2000 meeting, the staff cut the projection sharply, reducing their near-term GDP growth outlook by more than a percentage point.  As noted, the Committee left its target for the funds rate unchanged at 6½ percent, but it shifted the balance of risks to the downside.  Market participants had originally been expecting the Committee to adopt a balanced risk statement, but the day before the meeting a Wall Street Journal article by David Wessel described in surprising detail how significantly the staff forecast had been revised down and signaled that the Committee would shift risks all the way to the downside. (“A Rapid Slowdown in the Economy May Speed Up the Federal Reserve,” December 18, 2000).

At the meeting, the Committee was divided over whether or not to go ahead and cut rates immediately.  Five Committee participants, including two voting members, indicated that they wanted to cut rates, although, in the end, neither of the voters dissented.   Several participants observed that they would have been reluctant to confuse the markets by switching from upside risks all the way to downside risks, but that the “unfortunate” WSJ article had solved that problem. 

Committee Vice Chairman McDonough argued against cutting because it would rattle markets:

…I don't think the banging of the gong of a rate change at this meeting is anticipated. Now, the markets are extraordinarily thin and very risk averse. And therefore, if we were to do something that might be deemed a bit too dramatic, I am not sure what the market reaction would be--especially what the second or third tier reactions would be after the first one. (pp. 59-60).

Governor Meyer made a similar argument for not cutting.  Chairman Greenspan observed that it was not yet clear that a cut was warranted, but that if subsequent information indicated a cut was necessary, he would convene a committee teleconference in early January in order to do so. 

Which is exactly what happened.  On January 3, 2001, the Committee met by teleconference.  The economic situation had deteriorated further.  The Chairman noted that the initial claims data that would be released the next day (he got an advanced look) would be poor.  He proposed that the Committee cut rates by 50 basis points, which it did. 

The economy officially entered a recession in March 2001.

Overall, while the episode illustrates that a concern about provoking an unwanted easing of financial conditions can slow the FOMC down a bit, it also illustrates that the economic situation can change rapidly, and the Committee can respond nimbly and aggressively.  A delay of a few weeks in the start of an easing probably doesn’t make any difference, certainly our economic models do not think so.  Still, Greenspan observed at the December 2000 meeting that models don’t predict recessions because they can’t foresee the nonlinear loss of confidence that triggers the downturn.  Governor Meyer observed on the January 3 conference call that the markets had been disappointed the Committee had not cut at the December meeting, and a 50 basis point intermeeting cut would provide “…a chance to reset the psychological tone and expectations.”  Perhaps being ahead of rather than even a bit behind a nonlinear loss in confidence matters more than our models can capture.

As always, please feel free to share this email with anyone who might be interested.  If anyone would like to be added to this free distribution list, they should just email me. 

Bill