The Tail that wagged the Dog

Posted on September 18, 2015 by Greg

We all love to talk about the Fed, and I can’t help myself either, so here is my two cents worth.

In my humble opinion it was a tactical error for Yellen to allow a no rate hike decision, it contributed to, rather than helped reduce global market uncertainty and missed an opportunity to take control of the debate and display consistency of message.  It is probably not a crucial error and more than likely the cats will be herded sufficiently into the basket for the Fed to hike in December, reminiscent of their actions in 2013 when they walked the market up the hill to expect QE tapering in September, disappointed, only to proceed a few months later.  At that time they were roundly criticised for lack of consistent communication.  They will probably avoid much criticism this time, since the market never really bought the story, and there are reasons to be more cautious, but it would be better if the Fed had stuck to a plan, rather than poking its finger in the air and looking up to guess which way the clouds are blowing.

One thing the Fed has consistently done is move the goal posts on its neutral rate of unemployment and long term rates, so some might be excused for thinking that the Fed may never get around to hiking rates, until the day they suddenly rush to hike at the first whiff of inflation, fearing they are behind the curve and making a mockery of the slow and steady forecast.  But as Edwin Starr might have said “what are forecasts good for?......).

The tail that is global financial market volatility has wagged the dog that is the Fed that decides on rates. If global financial markets were to calm down, the Fed would be inclined to proceed with hikes.  But of course the Fed’s lack of predictability is contributing to those weaker global financial market conditions.  Quite probably, but we will now never know, if the Fed had hiked rates, global financial markets may have improved, thus making the hike a positive for confidence and more sustained growth.

Having let go this prime opportunity to lift rates, many may be wondering what could possibly change between now and the end of the year that might swing the balance towards a hike.  A fair question, and this is pretty unclear.  It might be finely balanced, if so it won’t take much.  Yellen did say a rate hike was discussed and labour markets were expected to keep tightening.  A recovery in global equity markets may do the trick, although the lack of Fed clarity works against that.  Some further decline in unemployment combined with more stable global financial markets might do it, but it is hard to say.

Furthermore, the lower inflation expectations near term arguably give the Fed more time to wait to see if there is a significant blow-back to the US economy from weaker growth in China and weaker emerging market currencies, in which case why not wait until next year.  At least 2 more FOMC members thought so as the number anticipating the first hike will not be until 2016 rose from 2 in June to 4 in September.  And one member now wants to cut rates to negative.

Still the majority (13) of the 17 members see a hike this year, 7 think one and 5 think two, while one still thinks the Fed might have to hurry up and hike 75bp by year end, implying there might be a 50bp hike and a 25bp hike before year end, perhaps to make up for the no change policy decision today (probably the biggest hawk that dissented at today’s meeting in favour of an immediate hike – Lacker).  Emphasizing the greater uncertainty the rate dots got more dispersed for year-end despite it now only three months and two meetings away.

Some key quotes from the Yellen press conference:

The concluding summary/guidance (we discussed a hike, but held off):

“The recovery from the Great Recession has advanced sufficiently far, and domestic spending appears sufficiently robust, that an argument can be made for a rise in interest rates at this time. We discussed this possibility at our meeting. However, in light of the heightened uncertainties abroad and a slightly softer expected path for inflation, the Committee judged it appropriate to wait for more evidence, including some further improvement in the labor market, to bolster its confidence that inflation will rise to 2 percent in the medium term. Now, I do not want to overplay the implications of these recent developments, which have not fundamentally altered our outlook. The economy has been performing well, and we expect it to continue to do so.”

Weaker global economic and financial developments:

“Inflation, however, has continued to run below our longer-run objective, partly reflecting declines in energy and import prices. While we still expect that the downward pressure on inflation from these factors will fade over time, recent global economic and financial developments are likely to put further downward pressure on inflation in the near term. These developments may also restrain U.S. economic activity somewhat but have not led at this point to a significant change in the Committee’s outlook for the U.S. economy”

Market based inflation expectations weaker and we are monitoring

“Survey-based measures of longer-term inflation expectations have remained stable. However, the Committee has taken note of the recent declines in market-based measures of inflation compensation and will continue to monitor inflation developments carefully.”

Concerns over China and emerging markets have tightened US financial conditions

“The outlook abroad appears to have become more uncertain of late, and heightened concerns about growth in China and other emerging market economies have led to notable volatility in financial markets. Developments since our July meeting, including the drop in equity prices, the further appreciation of the dollar, and a widening in risk spreads, have tightened overall financial conditions to some extent. These developments may restrain U.S. economic activity somewhat and are likely to put further downward pressure on inflation in the near term. Given the significant economic and financial interconnections between the United States and the rest of the world, the situation abroad bears close watching.”

Currency thoughts:

The currency implications of this rate decision are somewhat supportive of those other currencies that are funding currencies in times of improving risk appetite with near zero or negative rates (EUR and JPY). US rates are now more uncertain and that uncertainty is skewed towards no change for longer, although with a central case that they will still be higher by year end.  That has been immediately reflected in the EUR and JPY, although both are not at compelling levels to buy.  In fact my bias remains to sell both, but just not now.

It is a mixed bag for riskier higher yielding currencies, since the Fed is paying more attention to global risks, in particular, China, and worried about the USD strength against emerging currencies. This suggests that we all should be waiting and watching to see what happens in China next, implying investors, like the Fed, should be sitting on their hands.

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