Fed is people-dependent

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Markets have had to contend with slowing global trade and growth, collapsing EM currencies, commodity prices and equity markets topped off by Brazil’s credit rating downgrade to junk status and a surprise renminbi devaluation.

Perhaps most problematic has been policy-makers’ lack of direction and vision. The US is gripped by election fever and the ever growing list of presidential candidates. The Chinese government and central bank have multiplied policies to deal with slowing growth and wild stock-market gyrations, so far with seemingly limited success. The eurozone – still reeling from the Greek debacle – is divided about how to deal with an immigration and refugee crisis. The UK is pondering the implications of a newly elected extreme left-wing opposition leader and a likely referendum on EU accession while the Bank of England blows hot and cold on whether to start thinking about hiking rates. On the other side of the world Australia has got its fifth prime minister in five years.

But it’s arguably the US Federal Reserve’s lack of a unified message which has kept markets on tenterhooks ahead of Thursday’s policy meeting.

Fed’s “data dependence” is ill-defined

The Fed is supposedly “data-dependent”. The problem is that it is unclear what relative weights it attaches to macro data – namely growth and inflation – versus financial data characterized by weak and volatile global equity markets but somewhat more robust bond markets. Currency developments, namely the strength of the US dollar – up a further 2.5% in trade weighted terms since the 29th July Fed meeting – and EM currency weakness sit awkwardly between macro and financial developments; or more accurately they are both policy tools and by-product of market supply and demand.

Furthermore it is unclear what relative weights the Fed attaches to decent domestic macro data versus global macro data which, bar a few small exceptions, have been weak (emerging markets and commodity exporters), losing momentum (Japan) or getting stronger but from a very weak base (eurozone).

Fed is people-dependent

So Thursday is as much about the ten voting members of the Federal Open Market Committee (FOMC) making a decision as to the data they are analysing and interpreting. Perhaps unsurprisingly they have different takes on where the US and global economy are heading and therefore when to start hiking the US Fed fund rate.

Figure 1 highlights some of their most recent comments, which are categorised as neutral (yellow), dovish (blue) or hawkish (orange). I am fully cognisant of the subjectivity of such an exercise. For starters, we don’t have much of a track record to work from – of the ten current voting members only three have ever voted for a Fed fund rate change and that was a very long time ago (Yellen, when she was San Francisco Fed President, and Lacker voted for a hike in 2006 while Evans voted for rate cuts in 2008). With this caveat in mind:

Two members – Fischer and Lacker – are clearly in the hawkish camp and pushing for the Fed to hike sooner rather than later.

Two members – Dudley and Evans – are in the dovish camp. However, Dudley’s comments precede the release on 27th August of a far stronger than expected upward revision to Q2 GDP growth to 3.7% qoq annualised. Evans’ comments, while very dovish, are now more than two months old.

Three members – Lockhart, Powell and Williams – are seemingly still sitting on the fence. Note that Powell’s comments are now more than six weeks old.

Three members – Yellen (who has the casting vote), Brainard and Tarullo – have not recently commented publicly on US monetary policy or the US economy.

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Figure 1: Ten voting FOMC members – and a spectrum of views

Hawks outweigh doves amongst non-voting FOMC members

The five other FOMC members – Bullard, George, Mester, Rosengren and Strine – will attend Thursday’s meeting but will not vote. Recent comments by Bullard, George and Mester have a hawkish tint while Rosensgren’s comments are balanced with a dovish bias. Strine, whose appointment was effective 1 July, has not publicly commented on the US economy or Fed monetary policy in recent months (see Figure 2).

Figure 2: Hawks outweigh doves amongst non-voting FOMC members

Figure 2: Hawks outweigh doves amongst non-voting FOMC members

Based on the dovish lean of the voting members, I’m forecasting rates to remain on hold, which is more closely aligned with market pricing. Analysts, policy-makers and academics are very much divided.

Market

The Fed fund futures market is pricing in only 5-6bp of rate hikes at its policy meeting on Thursday – put differently the market attributes only a 20-25% probability of the Fed hiking its policy rate from 0-25bp to 25-50bp. At the surface this suggests market participants think the Fed will, rightly or wrongly, give greater weight to weak global growth, inflation and equities than to signs that US growth and tighter labour market (including 5.1% unemployment) could become inflationary.

Analysts

Analysts are split down the middle – in a recent Bloomberg poll, 37 out of 75 analysts forecast rates on hold, 37 forecast a 25bp rate hike and one thought the Fed would innovate with a 12.5p hike. I can see the attraction of an unconventional 12.5bp hike, even if it is not my base case scenario. It would take the policy rate to a simple 25bp (rather than the current band), be closer to what the market is currently pricing in and tally with the consensus within the Fed that the rate hiking cycle needs to be slow and gradual.

Officials and policy-makers

Prominent officials, policy-makers and academics are divided about what the Fed will do or at least what the Fed should do on Thursday (and the implications if it doesn’t). International institutions such as the World Bank and IMF advocate rates remaining on hold while a number of emerging market central bank governors are calling for an end to the Fed’s zero-rate policy (see Figure 3). The latter’s argument is that a Fed hike would remove the uncertainty that has gripped the market. I don’t think it’s that simple.

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Figure 3: IMF and World Bank dovish, EM central banks see benefit of Fed hike

Fed can offer vision, not certainty

To the extent that the Fed is data-dependent it cannot offer certainty, because data (and market developments) are uncertain, not to mention open to conflicting interpretations. Therefore the Fed can offer guidance, a well-defined set of targets and a vision, but that’s not the same as certainty.

If the Fed hikes on Thursday, the uncertainty will temporarily fade but will be rekindled as we head towards the Fed’s 16th December meeting. If US and global data and financial markets disappoint in coming months, the market will have to contend with the uncertainty of the Fed contemplating cutting rates. At the very least the Fed could pause for a very long time (“one and done”) which arguably equates to a tacit admission that perhaps it was wrong to hike in the first place.

Another argument in favour of a rate hike this week is that it would signal that the Fed is confident about the US economy or perhaps knows something that markets and analysts don’t. But in a world where nearly everyone has access to most of the numbers, it’s unlikely that the market will suddenly believe that the US economy is doing far better than we thought.

Finally, the hawks have argued that hiking rates now would give the Fed room to cut rates if/when US growth started to slow again. But if hiking rates weakens the US and/or global economy, having the room to cut rates once or twice won’t help much, particularly if the Fed’s credibility has been dented in the process. Put differently, why take the risk of creating a problem just to give yourself a solution (cutting the nose to spite the face springs to mind).

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

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