Many observers expect the Federal Reserve to keep interest rates unchanged at this week’s FOMC meeting, an expectation supported (at the time of writing) by prediction markets. At the same time, the inflationary pressure from renewed conflict in the Middle East could cause investors to consider the possibility of a rate rise.

In short, business largely as usual. But there is one notable difference from previous years. This week’s FOMC meeting will be the second since Kevin Warsh was appointed as chairman of the Federal Reserve. Warsh has decided not to deploy forward guidance, whereby the Fed signals its intentions to the market.

Hall of mirrors

Warsh’s reasoning is that markets are less efficient when they’re assessing how the Fed is likely to respond to changes in economic fundamentals, rather than reacting also to what the Fed suggests it is going to do.

As Warsh suggests, this feedback loop can distort markets themselves, obscuring our sense of what’s really going on in the economy: “Financial market prices are probably the most important source of information to guide central bankers. But when all the financial markets are doing is reflecting back what we’ve said, then we’re taking the most important source of information and we’re being blind to it.”

The Covid shock was a case study in potential downsides of forward guidance. As economist Felix Martin points out, markets priced in low rates – as signalled by the Fed – even as core inflation was rising.

Generating uncertainty?

But that’s not necessarily the whole story. As Martin explains, central banks need to guide direct investors into believing they would act in a particular way, should circumstances require it, in order for the policy toolkit to work effectively.

We can see how the absence of forward guidance is affecting decision making. ING analysts caution that the lack of forward guidance, “could encourage precautionary USD buying ahead of the announcement.” In the absence of signalling, more investors could be incentivised to hedge against a surprise rate increase.

Far from cutting through the noise, Warsh’s approach may leave markets with more uncertainty, not less. The challenge for investors is no longer interpreting what the Fed says it will do, but determining what it is likely to do before it says anything at all.

All opinions, news, research, analysis, prices or other information is provided as general market commentary and not as investment advice and all potential results discussed are not guaranteed to be achieved. The information may have been derived from publicly available sources, company reports, personal research, or surveys. Past performance is not indicative of future performance. Trading carries risk of capital loss. Service available to professional clients only.