The long and short of Fed policy
Fed Presidents Dudley, Williams and Lockhart comments on Monday/Tuesday have helped lift US rate hike expectations modestly and arrested a sharp slide in the USD. While all three see a rate hike later this year based on current perceptions of how the economy is currently tracking, Dudley and Williams have brought more attention to their views that the long-run neutral rate is lower. Therefore policy is not particularly accommodative and the Fed has not far to raise rates in the current cycle, suggesting that the Fed will remain hesitant to hike. Dudley said a hike in September is possible, but the tone of his remarks suggest he prefers to assess economic conditions through to December before giving serious consideration to a hike. The other factor that continues to drag on the USD is a renewed rise in JPY. The market continues to doubt that the BoJ or Japanese government have any significant policy measures to offer that will arrest the recovery in the JPY. We are not convinced that a Fed leaning towards a hike later this year will provide much lasting support for the USD. We see scope for gold to resume its recovery, taking its cue from a stronger JPY and supported by funds seeking safety from equites where valuations are getting stretched.
The long and short of Fed policy
In a volatile session, the FX market has responded to two lines of thought on the Fed policy outlook. The dollar appeared to weaken on a number of reports focusing on longer-term ponderances about a lower neutral policy rate, suggesting that the Fed will be slower to hike and hike less over the cycle. It then rallied on a comments from NY Fed President Dudley that focused on the short-term, arguing that a hike as soon as September was possible and the market was complacent in general to the risk of higher rates over in the coming year.
The long-term argument has been playing out through the course of this year, but heated up in the last month or so since Brexit. Despite the rebound in US payrolls in June and July, Fed speakers have been ambivalent about the prospect of a rate hike, in contrast to their assessment as recently as the beginning of June (before the weak May payrolls report) that hike was likely in the Summer.
There have been a lot of moving parts since Brexit and the world may be a more uncertain place, suggesting that the Fed could afford to wait a while longer before hiking rates, even if payrolls had rebounded and the US economy appears back on the same broad track over recent years towards full-employment. But the market has gone further than this, pricing in only one full 25bp rate hike over the rest of this year and all of the next. This is remarkably pessimistic in the context of the Fed’s policy outlook presented over recent years and the fact that unemployment is now very close to the Fed’s most recent assessment of full-employment.
But the market has witnessed the Fed’s persistent downgrade of the neutral policy interest rate and GDP growth potential over recent years and the slower than forecast rise in rates (only once so far in December last year). Such that it is more reluctant to believe that the Fed will hike when it says it might, and apt to believe that if there is any doubt, it will leave rates unchanged, and possibly even resume policy easing.
Feeding this sentiment has been an ambivalence in the Fed’s rate outlook commentary in the last month. In contrast to the May commentary that a hike in the summer was “likely”, key Fed members have only said in the last month that a hike this year was “possible” and the market was “complacent” to this risk. This illustrates much less conviction than in May, and not enough to move the needle in a skeptical market.
Furthermore, there has been a breakout of longer term dovish Fed Presidents such as Brainard, Evans and Bullard that appear to have shifted stance to suggest that the Fed should keep rates down until there is a clear indication that inflation is moving above the 2% target. These Fed Presidents have been influenced by the idea that the structural potential growth rate and therefore neutral policy rate is lower, uncertainty is higher, and the proximity to the lower (near zero) bound for rates creates an asymmetrical risk arguing for erring on the side of being behind the optimal policy tightening curve. In other words, keep policy very accommodative until you see the whites of inflation’s eyes.
Even those such as Dudley and Williams that have kept the faith that a hike is “possible” before year end have also spoken of the lower long-term neutral policy rate and more persistent than earlier forecasted headwinds to growth.
The fall in the USD in the last month owes much to this increasing skepticism that the Fed will hike rates in the foreseeable future and that even if they do it will be much slower than previously advertised. Consider the prospect that the Fed hikes once this year, it will barely look like a tightening cycle at all, with two hikes made in two separate years. The market might wonder if a third hike is even on the horizon.
Dudley warns on complacency
Dudley’s interview on Fox Business News on Tuesday triggered a sudden correction in the weaker USD, although its effects have faded through the day. Dudley said, when asked the specific question on whether the Fed might hike in September, that is was possible. This is a far-cry from likely, and the tone in his voice suggested that it was unlikely.
His assessment of the economic outlook was that “it was OK” and “growth would be stronger in the second half” than the weak first half and “we are getting closer to the time when we will have to snug up interest rates”.
He said that, “the economy is generating reasonable job gains of 190K in the last three months”, and “we are seeing signs that wage gains are starting to accelerate”, leading to the conclusion that, “we are edging closer to the time when it will be appropriate to raise interest rates.”
He said, “core/underlying inflation trends have been pretty flat in recent months”. That, “consumption is doing quite well, real income and jobs growth was pretty sturdy”. But, “there is some weakness in business investment” and election uncertainty “may exacerbate that for a little while”.
New York Federal Reserve President Dudley Fox Business interview – foxbusiness.com
My assessment of his interview is that a hike in September, while possible, and will be informed by important data such as one more payrolls and durable goods orders reports, is unlikely. But if sturdy trends continue through several more months and we move past the election, a hike in December will become likely.
Tentative over the cycle
But what of policy after that? Dudley reiterated his views expressed on 31 July that policy is “not particularly stimulative right now”, and that the “Fed does not have a lot of policy tightening to actually do”
So the market might conclude that it would not take much of a slip in the data to set the rate hike argument this year back on its heels, and that third hike remains highly uncertain, with the risk skewed, as it has been for throughout the current halting tightening cycle, towards it being long-delayed.
Williams is in the same camp
San Francisco Fed President John Williams, in an interview reported in the Washington Post, was somewhat more supportive of the case for a rate hike this year, and yet the market appeared to focus on his longer term assessment that central banks and governments may need to come up with new approaches to deal with low long term neutral rates. Williams authored a special report on this issue posted on the San Francisco Fed website on Monday.
Why this top official thinks the Federal Reserve should raise interest rates this year – WashingtonPost.com
Monetary Policy in a Low R-star World – FRBSF.org
In the WP, Williams said, with respect to the labor market, “Everything that we look at, they all have been showing good improvement and also levels that are consistent with being at or very near full employment.”
And that, “We’re starting to see some improvements in wage growth. The challenge there is that with productivity growth being so modest — and with overall inflation having run around 1 percent or so in the last year — even wage gains of 2 ¼ or 2 ½ percent are still actually quite good.”
Asked the question, Williams said, he does expect a rate hike this year. He said, “We’ve been adding enormous policy accommodation over the past several years. As the economy gets closer to its goals, we can again pull our foot off the gas a bit and hopefully execute a nice, soft landing over the next couple of years.”
He also said he did not agree with the line of thought some have (including some other Fed members) that the Fed should wait for inflation to rise back to target. He said, “I’m definitely not one of those who thinks we should wait until we see inflation get to 2 percent before we raise rates. I think that would put us significantly behind the curve.” He expressed concern that this might cause problems including a build-up of excessive risk-taking and asset prices.
However, in the longer term, Williams is also seeing a shallower policy tightening cycle, and argues that central banks and governments need to prepare now for new approaches to deal with cyclical slow-downs in a low neutral interest rate environment.
He alluded to these views in the WP article but they were fleshed out in the FRBSF website. They included a potential greater role for more countercyclical fiscal policy, such as tax rates that adjust with the unemployment rate, targeting a higher inflation rate, or target a nominal GDP growth trajectory.
These thoughts argue that central banks in general push harder for higher inflation outcomes, enlisting the help of government policy, to create a greater buffer away from the lower bound for interest rates. They contribute to the overall sense that the Fed is moving towards a more dovish assessment of policy, even if they do eek out another small rate hike in coming months.