Signalling Failure

From today’s FT:

The US Federal Reserve is keen to revamp its forward guidance about future interest rates but terrified of a market misunderstanding, according to the minutes of its September meeting. They show an active Fed debate about what to do with its pledge of low rates for a “considerable time” after asset purchases stop in October, but no concrete ideas about how to replace it.

Am I the only one who’s thinking this is bordering on ridiculous? And dangerous?

But when it came to changing it, a number of officials, “noted that changes to the forward guidance might be misinterpreted as a signal of a fundamental shift in the stance of policy that could result in an unintended tightening of financial conditions”.

It is not very hard to imagine that the Fed is playing a very unsafe game here by deciding not to change the forward guidance to something with more clarity and credibility, especially in light of the potentially large capital flight from the Eurozone as they’re trying to escape negative interest rates.

This reminds me of railway track signalling: “wrong-side failure” is ‘a failure condition in a piece of equipment that results in an unsafe state. A typical example would be a signal showing a ‘proceed’ aspect (e.g. green) when it should be showing a ‘stop’ or ‘danger’ aspect, resulting in a “false clear”‘.

The remedies are obvious. First should be the realisation that forward guidance causes too much confusion. Recently, when markets were confused, they erred on the side of optimism, believing in the Fed ‘put option’. Second, for better alternatives to be considered – for instance, for there to be no guidance at all.

Or in locomotive terms, it shouldn’t be up to the train driver to figure out what red, or green or amber may or may not mean. If you want to put up a traffic light that no one understands, then you’re better off not putting up any at all.


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