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The Institutional Risk Analyst

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Interview: Robert Brusca on the Federal Open Market Committee

Updated: Jun 11

June 10, 2024 | In this issue of The Institutional Risk Analyst, we feature a conversation with Robert Brusca, Chief Economist of Fact and Opinion Economics. Bob was a Divisional Research Chief at the Federal Reserve Bank of New York (Chief of the International Financial Markets Division), a Fed Watcher at Irving Trust and Chief Economist at Nikko Securities International. We spoke over lunch at The Lotos Club earlier this month.

Robert Brusca

The IRA: Bob, good to see you again and, as usual, in interesting times. You have been pretty critical of “how the Fed chooses to communicate with us” in your recent writings and also how the FOMC seems to change the meaning of language depending on the time of day and the context. You have spoken of being “very disturbed” by statements from Committee members. Going back to when Treasury Secretary Janet Yellen became Chairman in 2014, the Fed has talked of being data dependent, but then changes the meaning of that data through time. How do investors and consumers make sense of what the Fed is saying?

Brusca: You have to try to understand what the changing standard or goal of the Committee is today. Some people argue that the Fed is too data dependent, a statement that I find shocking. I can’t imagine anything further from the truth. To me the problem is not data dependence. Rather, the Fed sees the data or they ignore the data, or they try to cram the round peg into the square hole metaphorically. This year, when the FOMC came up with three rate cuts, it was not an official policy. It was only in the “dots,” but still the markets took this as guidance.

The IRA: Correct. The dot plot is a truly idiotic indicator of public policy, but it also seems to be what passes for objective policy guidance at the Board of Governors, at least so far as the media is concerned. The whole process whereby the Fed communicates with the public has become a media circus.

Brusca: The dots showed where the members were leaning, the number of cuts, etc. When the data started to go against the idea of three rate cuts this year, they kept saying “yes, but” until that position became untenable. Then it became “yes, oh, I guess we can’t do that.” It took three different inflation reports before the Committee decided that they really could not go ahead with three rate cuts.

The IRA: Is the Fed too open? Do the dot plots get the Fed in trouble with the media and Congress by communicating too much? Do we need FOMC members on the financial media every day? And having provided the dot plots, the Fed cannot withdraw the forward guidance when the data changes. Is the Fed guiding expectations or is the media?

Brusca: The Fed is herding the media and the markets. Because of that, when the Fed does things, the media and the markets react. And this, in turn, causes the Fed to be circumspect in taking action because they know that the media and the markets are watching. For example, when the Fed is getting ready to cut the target for interest rates, it doesn’t want to let you know too far in advance. Otherwise the markets might react ahead of the Fed and even undermine its plan.

The IRA: When we worked at the Fed of New York, we just acted. We did system repurchase agreements or intervention in the foreign exchange markets with no warning whatsoever. We did system RPs mid-morning or even before the opening on the NYSE. Two financial crises have turned the private markets into a high school lab experiment curated by the Fed. Would it be better if the Fed spoke less and simply acted when it comes to the markets?

Brusca: That is what I have always thought. I left the Fed in the mid-1980s and became a Fed-watcher, so I went from being an insider to being an outsider. In those days, Fed officials did not talk, but there were numbers. You looked at the reserve numbers and you looked at the data for open market operations. You looked at what they did and the details of the numbers, you could figure out that they were trying to achieve. But now forty years later, they are talking. Language is evil.

The IRA: Language is certainly imprecise, especially in politics. There is nothing more political than money. So then we are not data dependent, but rather language dependent. You and other Fed watchers actually look for the portions of the Fed minutes that were pasted verbatim from the previous month. It’s like the folks at PentAlpha looking for anomalies in the documentation for a new ABS deal.

Brusca: Language offers the prospect of deniability. It’s not just that conversation is an imprecise form of communication, but language may actually be intended to deceive.

The IRA: Of course, former Fed Chairman Alan Greenspan comes to mind. Uncle Alan dissembled better than any Fed chief in the past fifty years.

Brusca: For Greenspan, the obfuscation was out in the open. His middle initial was “O” and he was a believer in all of the Ayn Rand stuff. When the markets fell apart and he discovered there was all of this cheating and cutting corners in finance, he was shocked. Greenspan truly believed that efficient markets would discipline behavior and that people would not commit fraud and do stupid things that undercut reputation. Since 2008, the Fed and other agencies have reassessed the way markets work and changed the rules accordingly, so today it is all about being in the middle of the pack. You can always fail, but if you look like the pack in terms of risk, you are safe because the pack cannot fail.

The IRA: As Ulrich Beck and Anthony Giddens said, it is “the socialization of risk.” The managers run the world, spawn passive investment strategies and, also, have decided that we all need to invest in private credit opportunities this year. Talk a little more about how the Fed’s clumsy efforts to “communicate” are creating problems for markets and investors.

Brusca: Back in 2015, we had come out of the financial crisis and the Fed was looking for an opportunity to raise rates. Chairman Ben Bernanke, being an expert on the Great Depression, argued that you could not raise interest rates too soon. The Committee was initially impatient but became more focused on rate hikes in 2015. They did not want to leave rates too low for too long, even though oil prices had collapsed in 2015 and other deflationary conditions persisted, they hiked. They were actually trying to get rates back to normal, but they could not say that publicly because the markets would react adversely- too quickly. The Fed wanted to get rates higher on its own schedule not on one set by the markets. And members also were not at all in agreement of what “normal” was or even is today.

The IRA: Well, the Fed cannot seem to define “price stability” accurately, but we can certainly say that “normal” for commercial real estate is at least 2% price inflation annually. At least. Do you think that Fed Chairman Jerome Powell or his colleagues have a picture in their minds as to what “normal” interest rates or r* really are today?

Brusca: At that time they were estimating r* values, but you cannot really calculate it and we try to guess where r* exists. Concepts like r* do not exist in the empirical world. You must use a model to even estimate it and we’ve had all of these changes and shocks in recent years. How do we rely on an empirical estimate drawn from this shifting period? The Fed tries to describe things like r* or 2% inflation, but they do not articulate how they are going to get us there. So in 2015, the Fed finally raised interest rates and there was a lot of concern about possible deflation. But Vice Chairman Stanley Fisher warned that the Fed was ready to hike rates aggressively and markets were not prepared. It turned out he was wrong and the markets were right about the risk of deflation, as those risks lingered through 2017.

The IRA: So the Fed continued to push rates up through this period. Were they trying to normalize rates in 2016 and 2017 without saying so explicitly?

Brusca: I think the Committee was trying to normalize interest rates during this period, but it is important to understand that they were not as Chairman Powell does today, talking at every press conference and public appearance about the dual mandate. Methinks he protests overmuch. I see the profession of faith in the dual mandate as a cover story. Once you say that, you can do whatever you want in fact. Powell won’t hit the two percent target, but he won’t change the target either.

The IRA: So we get up to 2018 and the Committee continues to raise the target for fed funds until they discover this thing called bank reserves. The large banks led by JPMorgan (JPM) step back from the funds market at the end of Q3 2018, causing a generalized liquidity squeeze in the fourth quarter. What happened?

Brusca: In December of 2018, I was arguing that they should hold up on further rate increases. Larry Summers was also arguing that the Fed needed to focus on the lagged effect of all of the rate hikes since 2017. But more striking than such warnings was the Treasury yield curve, which was flat and perhaps was the most unusual yield curves I had ever seen. And yet the Fed was determined to raise interest rates because they had said so. This is the trap that the Fed now occupies. The Fed told the market that it’s going to do it and now the market expects it. Because markets expect it, the Fed has to do it – hoist on its own petard comes to mind.

The IRA: So it’s really about expectations at the end of the day?

Brusca: Of all the former economists from the Fed, I am perhaps most guilty of heresy when it comes to expectations. I am very much opposed to the idea that monetary policy and inflation is about expectations. While expectations are important, when they put these ideas in models and give them precise values, there is a disconnection from reality. People do expect things, and that motivates behavior, but all evidence suggest expectations are not accurate and should not be entered in models with such precise values. Like r*, nobody at the Fed knows the future and nobody understands how these assumed values interact with other variables. So at the end of 2018, they raised interest rates but also changed the forward guidance, leaving the markets unclear about whether the central bank intended to hike again. Systemic hikes were off the table but was the Fed done hiking?

The IRA: And by early 2019, the FRBNY was not so quietly buying MBS and TBAs to add liquidity to the markets. The FOMC cut the duration of the $8 trillion in MBS markets in half before mid-year of 2019. By June of 2019, the Fed was cutting interest rates explicitly and drove rates down to zero nine months later. And five years later, we still have no clear idea of what the Fed will do next.


Source: Bloomberg

Brusca: We should learn from our mistakes. We have learned a lot from the Great Recession, the Fed’s 2015-2018 tightening cycle, and then from its behavior under Covid. To the layman I’d describe this as a bit like Elon Musk and the self-driving car. Cars can drive themselves! But maybe they are not refined enough to replace humans in all driving endeavors. The Fed’s desire to use models and expectations is simply too ambitious, albeit academically correct, but unworkable in practical terms. The state of our ability to form expectations is not advanced enough for this to work.

The IRA: So what is the answer?

Brusca: The Fed itself, with more highly trained economists than anyone, the best software, the best hardware and best economic-intel, cannot forecast well, so how could every person or market do so well? How could their expectations set the standard? It makes no sense! The Fed needs to be less ambitious and more industrious (assume less, work more). Making policy from current data and deciding how past trends will play out while addressing how new events will affect growth is complicated stuff. By comparison, putting everything in a model and getting a forecast is simple once you have a model. But it might be completely wrong. That’s the trade-off. And the use of models is so attractive, so technological, sophisticated, so cutting-edge, the allure is hard to avoid. But when models depend on expectations they go awry. The Fed needs to analyze and handle more data. As Elon is finding out, too, auto pilot is not working. It may, some day, but its not working right now.

The IRA: Thank you Bob!

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