Fed says it best when it says nothing at all

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Portfolio managers, analysts and ultimately the market expect the Federal Reserve (Fed) to keep its policy rate of 0-25bp on hold at today’s meeting. Inflationary pressures remain subdued, economic activity has only started to recover after a lackluster Q1, the dollar TWI has appreciated a further 1.4% since the April Fed meeting and there’s the small matter of whether, or arguably when, Greece may default and the fall-out for the eurozone.

I would go a step further and expect the Fed to make only small tweaks to its economic and Fed fund rate projections and for Fed Chairperson Yellen in her post-meeting press conference to not say much beyond the Fed remaining data dependent and the rate hiking cycle to be gradual. A dose of boring may be what jittery markets actually need.

 

In a survey of 57 portfolio managers, analysts and finance specialists which I conducted a fortnight ago, only 4% of respondents forecast the Fed to pull the trigger at today’s policy meeting (Survey: Fed to lead Bank of England into slow and gradual rate hikes, 1 June 2015). The Fed fund futures market has similarly been pricing in only a very faint chance of a rate hike today. Nearly half of the survey’s respondents with a view (25 out of 55) expected the Fed to start hiking at its 17th September policy meeting, again broadly in line with market expectations but still a tad short of an overwhelming view.

So what, if anything, has changed in the past fortnight and since the 29th April Fed policy meeting to suggest that the Fed will wrong foot the financial community and hike rates today. The short answer is a lot but actually not very much.

 

  1. Inflation

With all the noise it’s easy to forget that the Fed targets personal consumption expenditure (PCE) inflation of 2% medium-term. Since the last Fed meeting, inflationary pressures have if anything eased further. The PCE price index rose 0.1% yoy in April, following 0.3% yoy in Q1 – an all-time low excluding the post-2008 financial crisis deflationary prints. Similarly, the year-on-year rise in the core PCE price index slowed to 1.2% in April from 1.3% in Q1. Of course the Fed is more interested in future than past inflation but one clear advantage (or disadvantage depending on which side of the inflation-targeting fence you sit) is that this temporal vagueness gives the Fed a degree of leeway.

  • The Fed could conceivably slightly lower its current Q4 2015 forecasts for PCE and core PCE prices from 0.6-0.8% yoy and 1.3-1.4% yoy, respectively, without doing much (if anything) to its 2016 and 2017 forecasts.

 

  1. Growth

Similarly, the Q1 GDP growth numbers at the margin provide the doves with further ammunition without being totally conclusive. Real GDP contracted an annualized 0.7% in Q1 – a far weaker number than expected, but there’s uncertainty as to whether sub-par seasonal adjustments, one-off events and particularly cold weather played tricks with the headline number. April data, particularly the “normalization” of the trade deficit point to a bounce in economic activity. Few expect a technical recession (two consecutive quarters of negative growth) given robust retail sales, employment and wages in May, a rebound in the manufacturing ISM and strong June consumer confidence.

  • The Fed may therefore again tweak its current 2015 GDP growth forecast of 2.3-2.7% lower in its quarterly economic projection whilst flagging the more recent recovery. Chairperson Yellen will likely reiterate the Fed’s data dependence, which at first glance seems like an obvious comment of little value-added. But my interpretation is that the Fed wants to see actual hard, final data, rather than estimates or forecasts before it makes hard choices because the economic picture is still somewhat out of focus.

 

  1. The dollar

The US dollar Trade Weighted Index (TWI) has weakened about 1% so far this month but appreciated 1.4% since the 29th April Fed policy meeting. The world’s top guns, including US President Obama, German Chancellor Merkel and Bank of Japan governor Kuroda have in recent days been forced to deny or qualify recent comments about their countries’ respective currencies predictably reigniting talk of “international currency wars”.

  • The Fed has quite rightly stayed out of the fray but is not insensitive to the negative impact of a strong dollar on corporate earnings and overall growth, even in the reasonably closed US economy.

 

  1. International environment

i .Policy rates:  Other G20 central banks are still sufficiently concerned about growth to cut policy rates, with the central banks of India, Korea, New Zealand cutting their policy rates 25bp at their June meetings. Bank of Korea cut its 7-day repo rate by 25bp to a record-low of 1.50% and the RBNZ’s surprised a market positioned for unchanged policy rates. China and Australia each cut 25bp at their May meetings and since the last Feed meeting the Central Bank of Russia has twice cut rates, by a cumulative 250bp.

ii .Greece: It is still unclear where the breaking point is for negotiations between Greece and its creditors. But there can be little doubt that the relationship between the Greek leadership and Troika has soured in the past fortnight and the debate is increasingly about the impact on Greece and wider European markets should the government default on its obligations to the European Central Bank, IMF and bilateral creditors.

While the Fed may not be overly interested in the minute details of these seemingly always-on-the-verge-of-collapse negotiations, it will be weighing their negative impact on market volatility, specifically peripheral bond yield spreads, and ultimately the eurozone’s tentative economic recovery. Furthermore, the cost of a Fed hike today in terms of likely market volatility, weaker equities and greater debt servicing costs on USD-denominated debt would arguably outweigh any competitiveness benefits to the eurozone and rest of the world from a stronger dollar. The OECD and IMF seemingly share this view, with the OECD recently slashing its 2015 and 2016 US growth forecasts to 2% and 2.8%, respectively, and the IMF calling for the Fed to delay hiking till early 2016.

  • While ex-ante there may never be an ideal time for the Fed to hike, there’s an argument that by September the Greek situation will have been resolved either way and that this may be a more benign time for the market to digest the first Fed hike in a decade.

 

The appropriate Fed fund rate – a slightly squatter “fighter jet”?

The Fed members may slightly lower their expectations for the appropriate federal funds rate for 2015 and beyond. Put differently, the Fed may push back the start of the hiking cycle but is unlikely to materially change its long-term path of gradual hiking. This would translate in the Fed “dot plot” for 2015 looking more squat – the “fighter jet” shape would have slightly longer wings and perhaps a slightly fatter tail (see Figure 1). In their March predictions the average “dot” for the Fed’s target rate was 0.625% for end-2015, implying two 25bps rate hikes (although the average was 0.75% implying two to three hikes) and 1.875% for end-2016 implying a full seven hikes.

Olivier Desbarres FED says nothing fig1

Figure 1: FOMC members may forecast a slightly later lift-off for the first hike
Appropriate pace of policy firming: Midpoint of target range or target level for the federal funds rate.

 

Respondents to my survey are even more adamant that the rate hiking cycle, when it starts, would be slow and gradual, expecting the Fed to hike rates by only 96bps between now and end-2016 – a similar path of tightening as priced in by the market.

Four rate hikes over the next 13 policy meetings would be in contrast to the last two Fed hiking cycles which saw pronounced and sustained monetary tightening. In the 12 months to June 2000 the Fed hiked five times by a total of 150bp and between May 2004 and June 2006 the Fed hiked rates 17 times by a total of 425bp, but GDP growth was in both cycles above 3%. The forthcoming, slower, policy tightening would arguably be commensurate with the far slower economic recovery recorded in the past couple of years.

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.


Sources

Fig 1 – FOMC projections, 18th March policy meeting

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