Tuesday, May 15, 2018

Saying What Was Obvious: How the Fed Can Shake Markets

Here is a situation that occurs regularly and would be scary if it weren’t so professionally managed. The U.S. Federal Reserve, which is responsible for setting the federal funding rate, issues a statement that discusses the state of the economy, sets target interest rates, and gives the reasons for these. The reason this should be scary is that this interest is directly linked to a massive amount of debt and indirectly linked to even more debt because it influences interest rates of loans taken by firms in the U.S. and made by lenders worldwide. Any loan has two sides, lender and borrower, so unexpected adjustments up and down will lead to losses for one side.

As you may imagine, the Fed crafts its statements carefully. There are data and analysis behind the discussion of the economy, there are reasons for the economic forecast and interest rate target, and there is often a discussion of how the premises of these reasons follow our taken-for-granted understanding of the economy. Everything is perfectly calibrated for a world of fully rational actors. But how about the world we live in, where it is hard to find anyone who is fully rational? That is the question answered by a recently published paper in Administrative Science Quarterly by Derek Harmon, and the answer is not encouraging. Maybe we should be scared after all.

His idea is the following: people are comfortable with data, reasons, and premises. What they are not comfortable with is talk about premises that are so accepted that they are taken for granted. If this sounds strange, consider the following: Usually we persuade by bringing up points that our counterparts are not aware of and should consider in order to reach our conclusion. That’s what data and reasons do. But taken-for-granted premises don’t work that way – we are all supposed to know them, so why talk about them? In a rational world, saying something that everyone knows makes no difference. In a world of bounded rationality it does make a difference, because saying something everyone is supposed to know, and does know, makes others question whether it is true after all. Saying what was obvious makes it debatable.

That’s deeply disturbing to financial markets because they have prices that are built on expectations about the future, and the expectations are fundamentally theoretical. As long as everyone believes in the same theory, their expectations are the same and everything goes well. If they don’t, there is confusion and fear. And that’s exactly what Harmon found. The VIX index of uncertainty goes up the more premises are stated rather than just assumed to be true. It gets even worse if there is already fear in the markets. The only situation in which stating premises is safe is when the Fed statement is overall optimistic about the future.

So what to do? The obvious recommendation is for the Fed to understand the fear created by stating the obvious and to stop doing so. At a deeper level, this is a reminder that financial markets are special because everything that matters happens in the future. No one is Doctor Strange, so the future cannot be visited, and instead everyone needs some agreement on what this future will look like. When the agreement breaks down, the result is usually bad, as we saw during the 2007/2008 financial crisis.