The day of reckoning is near, and market attention is focused on the US Federal Reserve (Fed). The timing of Fed “lift-off” has been a wild card for markets for many weeks, with the probability oscillating between September and December Federal Open Market Committee (FOMC) meetings. Economic data has been, on balance, supportive of Fed tightening, though recent market turmoil complicates the decision. Markets have pushed the odds of the first monetary policy tightening in over a decade to later this year. Fed officials, however, remain non-committal on timing. Recent comments indicate a lack of consensus on the relevance of recent market turbulence. FOMC Chair Janet Yellen may be challenged in navigating the discord that has developed within the Committee.
Exhibit 1: Market expectations - probability of lift-off on 17/09/15 as implied in market pricing on 14/09/15.
Source: Bloomberg as of 14 September 2015
The case for tightening is rooted in the improvement in the labour sector.
The Fed moved away from forward guidance earlier this year, instructing market participants to closely “watch the data”. The last FOMC statement provided clarification that additional improvement in the labour sector and confidence that inflation was trending to target were prerequisites for an increase in the target federal funds rate. Last month’s employment report, though mildly disappointing on a headline basis, was consistent with labour sector improvement. In fact, unemployment reached the Fed’s current estimate of full employment, suggesting that wage pressures will likely emerge if the trend continues. The Fed’s current policy framework suggests that the Fed should commence with policy normalisation in expectation of emerging price pressures. The six-plus-year expansion can be characterised as relatively mature, and the economy is healthy enough to withstand an increase in interest rates.
An alternative view focuses on the evolution of consumer prices.
US inflationary pressures are currently benign amidst a disinflationary global backdrop, a decline in commodity prices, and an increasingly fragile global economy. Market-based measures of inflation continue to forecast low levels of US inflation for over a decade. The Phillips curve framework, which serves as the basis for monetary policy and inflation expectations, has been called into question. The concept of full employment or NAIRU (non-accelerating inflation rate of unemployment) is very difficult to gauge, and the empirical relationship between unemployment, wages and prices is murky at best. The fact that inflation has remained persistently below the Fed’s target despite extraordinary policy stimulus measures has sparked renewed discussions on the effectiveness of monetary policy. Given the risk of a policy error, it may be best to wait for evidence of emerging price pressures.
It is also difficult to discount the recent turbulence in global markets.
Markets reacted violently to the surprise devaluation of the Chinese yuan tightening financial conditions. Global equity valuations dropped, credit spreads widened, and the trade-weighted US dollar strengthened. The systemic nature of the global correction suggests that the US is not immune to the challenges in the developing world. Changes in financial conditions may have preempted the Fed as increased headwinds to US growth argue for continued policy patience.
The fact that both arguments are credible makes the FOMC challenge more difficult.
In order to preserve credibility, the Fed needs to adequately manage market expectations. In this case, the message may be more important than the action. A preemptive tightening accompanied by lower forward guidance on the pace of policy increases may be the best course of action. The removal of uncertainty would likely reduce volatility in markets and increase financial stability. As with quantitative easing taper, markets may be viewing the bark as worse than the bite.
At FFTW, we are comfortable that FOMC Chair Janet Yellen understands the risks and challenges associated with this historic change in monetary policy.
Every effort will be made to maintain credibility in the face of rising uncertainty. Markets are unlikely to be shocked by the policy announcement on 17 September 2015. The outcome the FOMC meeting (of the week beginning 14 September 2015) will provide insight to the Fed’s reaction function, with the press conference and accompanying statement providing transparency to the Fed’s plan for the early stages of policy normalisation.