investing James Saft |
New data show not only that the Federal Reserve "leaks" or informally guides the market about its intentions, but also that its intentions are, on the whole, staggeringly positive for stock markets.
The picture that emerges from a recently presented study of market returns around Federal Reserve board meetings is of an institution reliant on back-channel communications and one running a policy of "Heads you win/tails I lose" for the stock market.
That's not just a transparency problem, it is a policy problem.
The entire equity premium from 1994 to 2013 was earned in weeks in which the Fed either had a monetary policy committee meeting or its usual fortnightly board meetings, according to a study given at a recent conference by University of California Berkeley Prof. Annette Vissing-Jorgensen and colleagues.
That's right — all of your gains in the stock market above what you'd have made in risk-free treasuries were packed into those weeks when the Fed was in conference, weeks that were also marked by higher stock market volatility.
The reason? It's when the Fed leaks, or as it prefers, "informally guides" the market as to what its intentions in monetary policy are.
"We argue that a more plausible mechanism for information getting to asset markets is systematic informal communication of the Fed with the media and the financial sector," Vissing-Jorgensen and her co-authors write.
"We provide direct evidence of leaks, lay out a framework for the Fed's motives for informal communication, and provide asset pricing tests of this framework."
The Fed has faced pressure from some in Congress over an alleged 2012 leak to a financial analyst. John Williams, head of the San Francisco Fed, acknowledged at the conference the use of informal channels "in the past."
To be sure, these likely aren't rogue leaks but part of a communications policy intended to give the Fed more continuous control over monetary policy and to avoid shocking the market.
Yet the implication is that the leaks are, to judge by their effect, generally encouraging to someone holding a risky asset. This, then, is the famous, asymmetrical policy of the Fed made flesh, the idea that the Fed uses its powers in such a way that tends to support rising markets and undergird those that might fall.
An earlier study by the New York Fed has documented the same tendency of rising markets around rate-setting meetings, but this shows a similar phenomenon when the Fed has its board meetings every two weeks.
Don't markets hate volatility?
The paper calls the excess return a risk premium for news, asserting that the higher returns during weeks the Fed meets and — choose your term — "leaks" or "guides" the market about policy are to compensate investors for the possibility of negative news.
Yet the data show good market days on both sides of Fed meetings, which rather suggests that investors are not particularly scared of what news is coming.
This volatility could be explained by the disorderly and preferential way in which the "informal communications" are conducted. It is disorderly and preferential by definition in that the information is released to certain organizations, often the Wall Street Journal, and not others, not to mention information that goes to private analytical firms or banks.
As there is no formal schedule for when leaks appear, observers must know they will occur during those weeks and it is quite natural for there to be higher volatility. It makes less sense for this volatility to be accompanied by consistently higher prices.
Markets, I was always told, hate volatility, but apparently not of the "what did Santa leave under the tree for me?" variety.
There are two underlying problems with this state of affairs: First, it is unfair to a degree not obviously outweighed by benefits; second, it points to a Fed that is uncomfortably dependent on inflating asset prices to achieve its goals.
It isn't immediately obvious that sometimes surprising the market is a bad thing, especially for an institution that always seems to gratify, not scarify, investors.
It's also clear that pumping up asset markets concentrates gains at the top of the wealth scale, while having a poor record of creating sustainable job and wage growth.
The last 20 years are a sad litany of financial market risk-taking that inevitably goes too far. That the Fed appears afraid to shock the market and almost always delivers asset-friendly news helps to explain why.
James Saft is a Reuters columnist.