Is it a hawk, is it a dove, no…it’s the Fed
It has now been 260 days since the Fed hiked its policy rate 25bp (for the first time in a decade) and all we really know is that, in the words of Fed Chairperson Yellen speaking at the Jackson Hole symposium last week, “the case for an increase in the federal funds rate has strengthened in recent months”. Admittedly some of the more hawkish voting members of Federal Open Market Committee (FOMC), including Vice-Chairmen William Dudley and Stanley Fisher, have more forcefully made the case for a rate hike sooner rather than later.
But as forward guidance goes this is still of limited value beyond the Fed indicating, as it has done throughout most of 2016, that the next move will likely be a hike, rather than a cut, and that it will likely take place this year. As a result the market is still pricing only 7bp of hikes at the Fed’s policy meeting on 21st September and 17bp of hikes (using a weighted average) at its 14th December meeting. Similarly, in a Reuters poll in early August analysts attributed only a 25% probability to a hike in September, versus a 58% probability to a December hike.
Case for a Fed rate hike based on current data
The answer to what is holding back the Fed, and in particular Yellen, from adopting a more clear-cut hawkish stance boils down to one word: uncertainty. As I explore below in my updated US and global macro heat-map, the case for a rate hike, based on current US and global indicators, is in aggregate as strong as it was when the Fed hiked its policy rate 25bp in December 2015 (whether that hike was or future hikes are optimal is an altogether different question).
- The US economy it ticking over, with current GDP growth running above 3%.
- The labour and in particular housing markets have made further marginal gains this year.
- Inflation has inched closer to the Fed’s (implicit) 2% target and international commodity prices have rebounded.
- The US dollar Nominal Effective Exchange Rate (NEER) has been well behaved, trading in reasonably narrow range since May (see Figure 1).
- Admittedly the US manufacturing sector remains under pressure, characterised by low productivity, investment and confidence. But that was arguably also the case last year.
- Global equities are near multi-year highs, government bond yields near multi-year lows.
- Global GDP growth has continued to slow in recent quarters, as per Figure 2, but at moderate rate thanks in part to global central banks’ loose monetary policies (See Emerging markets – What will sour sweet spot? 29 July 2016).
US and global macro heat-map
One of the more obvious differences is that real GDP growth of 2.0% qoq saar in Q3 2015 – the last official GDP data point which the Fed had before it hiked rates in December 2015 – was twice as fast as the 1.1% growth recorded in Q2 2016 (based on the second GDP estimate) – see Figure 3.
However, the Fed would have had a good grasp that real GDP growth was slowing in Q4 2015 (to 0.9%) even if the preliminary GDP data were only released on 29 January, six weeks after the Fed hike. So in itself even GDP growth of around 1% may not be enough to dissuade the Fed from hiking rates. In any case the most recent GDPNow estimate from the Atlanta Fed has GDP growth currently running at 3.5% in Q3, which if confirmed would the fastest quarterly growth rate in two years.
All measures of current and expected US inflation are higher than in the months prior the December rate hike, but they have been largely flat-lining in recent months whereas they were slowly rising (albeit from a very low base) in the second half of 2015. The question is what weights the Fed will attach to the level and direction of inflationary measures. The growth in house prices has accelerated.
That’s now but what about tomorrow?
But the Fed, quite rightly, is looking ahead and has explicitly acknowledged that visibility for the US and global economy is poor, seemingly attributing a greater weight than previously assumed to international developments or domestic events which it cannot forecast with any degree of certainty. This in turn could be seen as the Fed’s tacit admission of a greater risk of “policy-error”.
The surprisingly weak US non-farm payrolls (NFP) number in May and unexpected outcome of the UK’s EU referendum (which sent global equity markets in a tailspin) are two of the more prominent recent events which may partly explain the Fed’s cautious disposition about what the future holds. The three percentage point fall in the manufacturing ISM in August – after two reasonably strong prints – may also have come as a surprise (it certainly was for analysts forecasting only a moderately weaker number in today’s release).
Moreover, going forward, there is the no small matter of the still too-close-to-call US presidential elections scheduled for 8th November. Donald Trump’s victory would arguably have a far bigger (and negative) impact on the US and global economy than a referendum on whether an economy with a GDP one-seventh of the US economy’s will tweak its trading arrangements with the EU.
Should US labour market data for August (due for release tomorrow at 13.30 London time) come out “strong”, this would admittedly remove a key hurdle for a September rate hike and at the very least see markets repricing higher the probability of such an event. This would likely require non-farm payrolls around 200,000 – near the year-to-date average of 220,000 (if the lacklustre May print of 24,000 is excluded). In this scenario, I would expect the Fed to gently encourage such a market repricing whilst emphasising that future rate hikes will be slow and gradual so that if it did hike in September the market reaction would be muted – unlike in Q1 2016 when global risk appetite tumbled on concerns that rapid Fed policy tightening would follow the December hike.
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.