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Ground control, we have a Fed communications problem

An eagle tops the U.S. Federal Reserve building's facade in Washington, July 31, 2013. REUTERS/Jonathan Ernst
An eagle tops the U.S. Federal Reserve building's facade in Washington, July 31, 2013. REUTERS/Jonathan Ernst

By Pedro Nicolaci da Costa

WASHINGTON (Reuters) - For a central bank that prides itself on transparent communications, the U.S. Federal Reserve has a clear messaging problem.

After months conditioning financial markets for a likely September start to a reduction in stimulus, the Fed's inaction this week stunned investors, leaving many wondering how much stock they can put on the verbal nods of policymakers.

The possibility of a trim to the Fed's $85 billion monthly pace of bond purchases in September had been pretty widely telegraphed by officials. A Reuters poll published last week found that 49 of 69 economists expected a move.

This week, however, Fed policymakers found themselves in a curious position: their plan to curb their purchases had led to a run up in interest rates they worried could harm the economy.

Now, traders are questioning whether the Fed will make any changes to its asset buying plans this year at all, indicating just how volatile the markets' forecasts for the path of Fed policy have become - despite assurances from officials that they are doing their best to provide clear guideposts.

More importantly, some analysts are concerned the bungled communications could lead markets to distrust the signals the Fed is sending, a potential problem for a central bank that increasingly is relying on forward policy guidance to influence borrowing costs.

"Credibility requires consistency," said Michael Cloherty, head of U.S. rates strategy at RBC Capital Markets. "The question now seems to be not if the Fed tapers this year, but rather when in 2014 do they taper."

SHOT IN THE FOOT

Global markets had gone into a tailspin back in May, when hints from Fed Chairman Ben Bernanke about a near-term tapering of the Fed's bond purchases pushed U.S. interest rates sharply higher, threatening a nascent housing recovery.

Bernanke added fuel to the fire in June when he said the Fed expected to begin pulling back on before year-end with an eye toward bringing the purchase program to a close by mid-2014.

The magnitude of the increase in borrowing costs - well over a full percentage point on the benchmark 10-year Treasury note in a matter of months - caught Fed officials by surprise, and appears to have been sufficient to deter them from dialing back their quantitative easing program for now.

"The tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market," the Fed said on Wednesday.

The Fed's surprise decision to keep its economic stimulus at full-throttle sparked a relief rally in markets around the world, which had been on edge for months on fears that the central bank's stimulus bonanza might soon begin winding down.

"The Fed botched its message in June and is trying to undo that mistake," said Jeffrey Gundlach, chief executive of bond fund Doubleline Capital. "The data does not suggest that the economy can make it on its own and once stimulus is sent on a lower trajectory it cannot be reversed quickly."

Not that the economic rationale for the Fed's decision to hold off was unsound. Third quarter economic growth appears to have softened following the second quarter's 2.5 percent annual pace, while the latest employment report for August was disappointing. At the same time, inflation remains well below the central bank's 2 percent target, giving policymakers plenty of head room to continue easing policy.

Perhaps even more importantly, the Fed's own growth forecasts were revised down, and rather sharply, for both this year and next. Officials now see 2014 GDP expanding between 2.9 percent and 3.1 percent, down from June's 3.0 percent to 3.5 percent range.

DOVISH MISCUES

One of the reasons markets were so prepped for the Fed to ratchet back its purchases was that top officials did little to dispel building market expectations of a September move.

Bernanke did tell Congress in July that the Fed would have to watch closely to make sure the run up in interest rates was not harming the economy. But few observers saw that as a signal that the Fed was getting cold feet about its plan to taper its purchases soon.

Indeed earlier this month, Chicago Federal Reserve Bank President Charles Evans, who is seen as one of the central bank's most dovish officials, said he might be prepared to support a reduction in September.

"There's been cumulative progress on the economy. I can be persuaded that there has been enough improvement," he told reporters in Greenville, South Carolina.

Joseph Gagnon, a former Fed board economist now at the Peterson Institute, says what the policy-setting Federal Open Market Committee did was consistent with the Fed's guidance that a pull back would depend on continued solid data.

But he acknowledged problems with the Fed's market signaling. "They made no effort in recent weeks to correct the prevailing market view that a taper in September was a sure thing," Gagnon said.

The mayhem has some analysts pining for the days, dominant under Alan Greenspan, when transparency was a lot more selective, and the Fed would not necessarily show all of its cards - thereby masking some of policymakers' own uncertainties about the outlook.

"We know that FOMC communications strategy has been highly influenced by elegant economic models that rely on forward guidance and commitment as key elements to removing uncertainty from market decision making as the means to ensure policy effectiveness," said Bob Eisenbeis, chief monetary economist at Cumberland Advisors and a former Fed staffer.

"Yet what events have revealed is that the FOMC values discretion in policy making above all, as witnessed by its insistence that policy moves and tapering are vaguely contingent upon incoming data. Such reliance is not forward guidance nor is it evidence of commitment."

(Additional reporting by Jennifer Abalan; editing by Andrew Hay)

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