Sep 17/15 – Is the Fed itching for a fight with the market?

2015-09-17 9am EDT  |  #Fed #Larry Summers #Yellen

Well today is the day. After what seems like months talking about whether the Federal Reserve will abandon their zero rate policy, the FOMC committee will finally lift the veil later this afternoon.

There can be no denying that as recently as the end of August, Federal Reserve committee members were still leaning towards raising rates at this September’s meeting. This can best be demonstrated by the rhetoric coming out of the mouth of the generally accepted number two Federal Reserve member after Chairperson Yellen. From the Guardian:

“In making our monetary policy decisions, we are interested more in where the US economy is heading than in knowing whence it came,” Fischer said in his remarks, which were released in Washington.

Fischer said there’s “good reason to believe that inflation will move higher as the forces holding down inflation dissipate further”. He said, for example, that some effects of a stronger dollar and a plunge in oil prices key factors in holding down inflation have already started to diminish.

And this attitude was by no means confined to Stanley Fischer. Most of the other FOMC committee members were also preparing the market for a September hike. From Reuters:

Last month Boston Fed President Eric Rosengren, who like Yellen has long advocated sticking with near-zero rates to get more Americans back to work, told Reuters even he could endorse a rate hike at the Sept. 16-17 policy meeting if labor markets continued to improve.

This week the Atlanta Fed’s Dennis Lockhart, a centrist whose views usually reflect that of the core decision-makers, said in a newspaper interview it would take a “significant deterioration” in the economy to convince him not to support a measured tightening next month.

New York Fed President William Dudley, among the most influential policymakers, has said he would be “very surprised if (the rate hike) was a big surprise to anyone” when it happened, implying that the central bank may have to work harder over the next month to prepare markets.

The Federal Reserve policy setters desperately want to shed the ZIRP (zero interest rate policy). So much so they were willing to attempt the lift off of zero even though inflation was consistently running below their 2% target. In the modern history of the Fed there has never been a tightening cycle started when inflation was running below target. Yet Yellen’s Fed was so frantic to lose their dovish monicker they tried to make history. Who knows, maybe they still will.

Those who want to tighten seem to take Wayne Gretzky’s famous line about skating not to where the puck is, but where the puck is going to be to heart. Atlanta Fed President Lockhart sums it up in this speech:

Key to my own thinking on impending policy decisions is the outlook from here. I expect somewhat stronger growth in the second half of the year. I expect the employment markets to continue to tighten. I expect continuing labor market progress to begin to put upward pressure on wages across the economy. And I expect convincing evidence to emerge that inflation is rising to a safer level and approaching our 2 percent target.

For me, the cumulative evidence of the economy’s healing, and the likelihood the economy is on a path to achieving the Fed’s mandated objectives, makes me comfortable that the economy can handle a gradually rising interest-rate environment.

Fed Chair Janet Yellen has stated she expects conditions to jell, justifying a start to policy normalization sometime later this year. I agree. I think the point of liftoff is close.

As the Committee approaches what I consider a historic decision, I am not expecting the data signals to point uniformly in the same direction. I don’t need this. I’m prepared to see mixed data. Data are inherently noisy month to month and quarter to quarter. Given the progress made over the recovery and the overall recent tone of the economy, I for one do not intend to let the gyrating needle of monthly data be the decisive factor in decision making.

The problem is that as the Fed skated to where the puck will be, the opposing team has already adjusted for their move. The simple act of preparing the market for the hike has caused a series of financial price adjustments that negates the need for the hike in the first place. The US dollar has rallied, import prices have collapsed and financial conditions have tightened. The Fed hasn’t needed to tighten to slow down the economy, the simple act of talking about it has been enough to cause it.

As the Fed’s tightening rhetoric has increased, there has been a growing chorus of financial leaders who have warned about a 1937 style mistake. Smart guys like Ray Dalio, Lloyd Blankfein, Jeff Gundlach and Ken Rogoff have all expressed concern about tightening too soon. During a recent Bloomberg interview Rogoff summed it up nicely:

KEN: WHAT IS THE LOGIC IN DOING IT [a rate hike]? I HAVE A LOT OF TROUBLE WITH THE IDEA OF LET’S DO IT NOW AND THEN WE WILL HOLD OUR BREATH AND LEAVE EVERYONE IN SUSPENSE. IF YOU DO NOT KNOW THAT YOU HAVE ROOM TO RAISE IT FOR A WHILE, WHY ARE YOU STARTING NOW? IT IS VERY ASYMMETRIC. IF YOU GO IN THE WRONG DIRECTION, IT IS HARDER TO DO SOMETHING ABOUT IT. I AM JUST LOST AT THE STRATEGY. I WOULD LIKE TO POINT OUT THAT THE EMPHASIS THAT THEY GIVE ON OUR MODELS PREDICT THAT INFLATION IS COMING — THE MODEL HAS NOT BEEN VERY GOOD FOR A LONG TIME, SINCE THE FINANCIAL CRISIS. WHY YOU WOULD WANT TO RELY ON THAT AND NOT MORE ON SEEING INFLATION, I DO NOT UNDERSTAND.

Even not so smart guys like Larry Summers have taken to petitioning the Fed to take their time with rate hikes.

Recently Larry took time out from his naps, to write a couple of blog pieces about why the mistake will be to hike too early. From Larry’s blog

Not content to simply publish one dissenting blog post, last week Summers wrote another piece titled Why the Fed must stand still on rates. His conclusion is unambiguous:

Now is the time for the Fed to do what is often hardest for policymakers. Stand still.

It is widely known that Summers wanted Yellen’s job, so this public pressure is all the more interesting. If the Federal Reserve committee does hike, and it blows up in their faces, Summers will be able to point to his warnings. If they don’t hike, then it will look like Summers helped influence policy. The only way Summers loses is if they hike, and everything is rosy. Given the stretched nature of markets, this is a low probability outcome. I am not sure about the asymmetry of letting inflation and the economy run a little hotter than usual given the unique economic circumstances, but I do know Summers is definitely taking advantage of the asymmetry in his political career.

So where does this leave us today? Will they hike or not? Of course the Federal Reserve would love to hike, but will they risk it?

There has been lots of chatter about the fact the Fed has never started a tightening cycle without the market having the first hike 100% priced in. Given that the market is currently pricing less than a 50% chance of a tightening, this would indeed be an unusual time to break this precedent. It would be even more unforeseeable given that Yellen has on multiple occasions stressed the Fed would give the market plenty of notice.

The correct bet is to assume the Federal Reserve will once again pass on raising rates. Every time they have gotten close, they always seem to find an excuse not to tighten. This would be an extremely unusual time for the Fed to pick a fight with the market.

Yet here is a thought. What if the market is never going to let them tighten? What if each time they prepare the market, things sell off enough to introduce doubt about their willingness to follow through? If that is the case, then they might as well just take the hit and get it over with. As Stanley Fischer recently opined, putting off a monetary policy move to wait for things to get clearer often doesn’t help – it is just unclear in a different way the next month.

Although I think the most likely outcome is for the Fed to pass at this meeting, I think there is a small chance the Fed finds a way to hike in a smaller amount than 25 basis points. Back in March, I wrote a piece about the possibility of the Fed hiking by only 10 basis points: Mar 2315 – The next Fed move is going to be only 10 basis points.

http://themacrotourist.com/images/Azure/Pulp25bpsMar2315.png

I still think this is a definite possibility. Right now the Fed funds target is between 0% and 0.25%. In daily trading, it averages somewhere around 12 or 13 basis points usually. So if they moved the rate up to a range of 0.25% to 0.50%, it would average around 0.375%. But right now the October 2015 Fed Funds future is trading 99.80. The market is pricing in a risk adjusted 20 basis point average Fed Funds for October. Why not increase the Fed Funds target to 0.15% to 0.25%? The Fed hawks would get the increase done with, but the doves would be able to say they did not hike more than markets were expecting. They would also be able to reinforce their commitment to any hikes being gradual. Again, I don’t think they are going to do this, but if there is a hike, it will not be a full hike, but instead some sort of way to hike to an effective rate that is not a full 25 basis raise.

Thanks for reading,

Kevin Muir

the MacroTourist