Interest rate volatility: Why Fed policy guidance is less effective

In less than a year, the swing in the 10-year yield has moved more than 350 basis points in both directions, a volatility not seen since the 2008−09 financial crisis.

The MOVE index, a measure of bond market volatility, has experienced what can politely be called excessive volatility since the Federal Reserve started its rate hike campaign in April 2021. More recently, the market's expectations for interest rate paths have undergone two major resets: one in October 2023 and another in January 2024.

In our estimation, the Fed needs to move away from a data-dependent stance and consider moving back to a forward-looking policy that uses a mixture of rules and judgment to shape market expectations and dampen excessive interest rate volatility.

Such an approach would be the next step in rebuilding the Fed’s damaged credibility and is a necessary ingredient in shaping the post-pandemic economy, which is almost certain to be characterized by higher interest rates, higher inflation and a strong dollar.

The primary driver of such volatility has been unexpected inflation news, both positive and negative, creating uncertainty as to the direction of rate policy.

The lack of confidence in the direction of inflation, especially during the first three months of the year, is the key factor influencing the Federal Reserve's decisions to raise or lower rates.

Beneath the surface, however, the absence of clear communication on monetary policy, the diminishing effectiveness of forward guidance, the impact of homeowners with mortgages of less than 4% and the overall regime changes post-pandemic have contributed to the Fed’s diminished ability to reduce inflation and have fueled volatility.

But the implications of such volatility extend even further. Central banks around the world, especially in emerging markets, have been affected by the significant fluctuations in potential interest rate paths because of the continued dominance of the dollar. 

In the post-pandemic world, where fragmentation has been transforming global trade, supply chains, and international cooperation, interest rate differentials will likely continue to cause disruptions, which in turn will further increase fragmentation. We are entering an economically and politically volatile era that will almost certainly feature more, not less, intervention in the global foreign exchange markets.

The International Monetary Fund recommended that Asian central banks become less dependent on the Fed’s decisions and focus more on internal policy decisions.

Housing disinflation, stabilizing energy prices and a cooling labor market this summer—as predicted in our base case—will likely lead the market to recalibrate its rate path once again, offsetting the developments of the past three months or so. But some damage, particularly to emerging markets and bond markets, has already occurred.

While the Fed is in a challenging position, we believe that returning to a more rule-based approach and clearly communicating that strategy to the market will significantly reduce financial market volatility.

Our preferred method is the Taylor Rule, which demonstrates how central bankers should respond to changes in inflation, unemployment rates, output and r-star, the natural rate of interest, over a longer period.

According to our estimates, the Taylor Rule suggests that the Fed has considerable room to cut rates in the second half of the year if inflation continues to slow. But a backward-looking, data-dependent approach would likely result in only two 25-basis-point cuts, with the possibility of more if the global environment worsens.

What the data is saying

Our analysis is based on data regarding how interest rate paths have changed over the past 12 months. From September 2023 to January 2024, the rate path declined significantly following approximately six months of unexpectedly positive inflation data. The policy rate’s upper bound was anticipated to decrease by more than 60 basis points, or nearly three 25-basis-point rate cuts.

But as of May—less than five months later—rate expectations for the end of this year were revised upward by about 100 basis points.

This is not typical financial market volatility. It closely aligns with developments in the bond market, where the 10-year yield exhibited the same pattern.

But these market pricing swings have not been in line with the Fed’s forward guidance. By examining the Fed Sentiment Index, created by Bloomberg, we can clearly see the misalignment between the Fed’s intended communication and market pricing.

This index uses a natural language processing model trained on Fed communications since 2009 to analyze tone. A reading below zero typically implies imminent rate cuts, while a reading above zero suggests tightening.

From June to October of last year, despite the Fed’s hawkishness as inflation remained persistent, the market was slow to recognize that interest rates would remain elevated. From October to January, after months of favorable inflation data, both the central bank and the market briefly turned more dovish.

But as inflation unexpectedly surged in the first quarter of this year, the market and the Fed diverged once again, with the market sharply increasing its rate expectations—completely reversing the brief dovish period—while the Fed maintained its hawkishness.

In his most recent remarks, Fed Chairman Jerome Powell adopted a surprisingly dovish stance, citing incoming housing disinflation and a cooling labor market—similar to our base scenario—as reasons to believe that the disinflation trend will resume. Based on that outlook, along with a lower-than-expected jobs report for April, the market is once again poised to recalibrate its rate forecasts.

In other words, the market prematurely overreacted to three months of unfavorable inflation data, which may be influenced by seasonal factors, while the Fed remained steady in its forward guidance.

This underscores the decreasing effectiveness of the Fed's forward guidance, which continues to rely on backward-looking data.

The misalignment between the Fed and the market also stems from a clear regime change in the post-pandemic world, which is likely to feature higher inflation and higher interest rates.

The market has only recently adjusted to this reality, pushing long-term yields higher. In contrast, the Fed is adhering to its 2% inflation target, which we believe is unsustainable in a world characterized by greater fragmentation and supply shortages post-pandemic.

Many, including our team, have advocated for a higher inflation target and, consequently, a natural rate of interest, r-star.

We do not expect the Fed to change its target ex ante, as doing so could potentially undermine inflation expectations. More likely, the Fed will adjust its target rate only ex post, as it has done previously. This approach also diminishes the effectiveness of policy forward guidance.

The MOVE index of U.S. Treasury market volatility

The degree of bond market volatility depends in part on the range of possible changes in interest rates. For example, the 10-year bond yield underwent a secular decline from nearly 8% in the early 1990s to 1%−2% during the era of zero interest rates after the 2008−09 financial crisis.

With interest rates restricted to movements with a tight range, volatility in the bond market was restricted as well from 2012 until the 2020 pandemic and economic collapse.

When interest rates operate under more normal policy conditions, the bond market has more latitude to respond to events.

For instance, when the Trump administration announced its trade war, the Fed was forced to end its interest rate normalization program. This caused the front of the curve to drop again and for the 10-year yield to retrace its sell-off, raising volatility.

In recent months, the 10-year yield has been determined by expectations of Fed policy. As such, volatility has increased with each Fed policy announcement and the jobs reports, with the market reacting to the prospects of economic growth.

The takeaway

The past year has seen significant volatility in financial markets, with dramatic shifts in the 10-year yield and multiple resets in market expectations for interest rate paths, primarily driven by unexpected inflation data influencing Fed decisions.

Underlying this turbulence are fundamental issues, including an unclear monetary policy framework and reliance on backward-looking data, that have exacerbated uncertainties and disrupted global economic stability.

Adopting a more rule-based approach like the Taylor Rule and clearly communicating it could significantly reduce market volatility, providing the Fed with flexibility to adjust interest rates based on economic indicators such as inflation and unemployment.