Fed in a catch-22 situation

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The minutes of the most recent US Federal Reserve's FOMC meeting showed a somewhat more hawkish tone than expected, raising the chance of an early rate hike. Prior to the release of the minutes FOMC members Loretta Mester of the Cleveland Fed and Eric Rosengren of the Boston Fed had also expressed relatively hawkish views.

Economists regularly discuss whether or not central banks should surprise financial markets or not. Han de Jong Han de Jong Chief Economist

  • Fed minutes more hawkish than expected...
  • ...but market participants are not convinced,
  • ...creating uncertainty in financial markets

Pros and Cons

Fed in a catch-22 situationIn deciding on interest rates, the Fed has to weigh up arguments on all sides. The most compelling argument, in my view, to tighten monetary policy is that official interest rates are lower than would appear justified by the current US economic conditions. The economy has been in recovery since 2009, unemployment has fallen significantly and inflation is trending higher, but official interest rates are still extremely low.

However, there is no good reason to hurry in my view. The Fed's preferred inflation measure, core PCE, is running at 1.6%, below the Fed's target of 2.0%. The average of the last five years is also 1.6%, so the Fed has undershot its inflation target for some time, though not to a large degree. Given this persistent undershoot, the Fed should probably be prepared to tolerate some overshoot, should that happen. In addition, economic growth really isn't all that strong and a variety of indicators suggest that several weak spots persist. These weak spots are certainly not enough to fear a recession, but they do reduce the urgency of rate hikes.

Another consideration to take into account is that monetary conditions have tightened in recent years, despite the lack of rate hikes (except the December 2015 lone rate hike). The end to the Fed's QE programme in 2014 and the appreciation of the dollar between mid 2014 and mid 2015 are equivalent to rate hikes. As changes in monetary conditions affect economies with long and variable lags, it is hard to say whether the effects of this tightening have fully worked their way through the system. In addition, credit spreads have tightened at times and the most recent Senior Loan Officers Opinion Survey suggest banks are tightening lending conditions.

Divergence from what other central banks are doing is also something to consider. There is no formal coordination of monetary policy in different countries, but it is highly unusual for key central banks to move in opposite directions. The effects this might have on, for example, the currency market may put a natural brake on divergence of policy.

Surprise

Economists regularly discuss whether or not central banks should surprise financial markets or not. My view is that a surprise can be useful, but predictability should be the rule. And in current vulnerable circumstances it would seem unwise to produce unpleasant surprises. I expect the Fed to see it the same way. If that assumption is right, the Fed must prepare markets if they seriously want to raise rates. And the more hawkish tone in recent communication is perhaps exactly trying to affect expectations.

But markets aren't really buying it. Money futures pricing suggests that market participants attach only a modest chance of an early rate hike and are not even fully convinced there will be a rate hike before the end of the year, let alone two which the FOMC members indicated as likely in March.

Why is the market unconvinced?

Financial market unrest at the start of the year led the Fed to take international developments into account and this unrest was a reason for the Fed to become less hawkish then. In recent communication, the Fed has referred to increased stability in international financial markets and the somewhat improved international economic outlook. This takes away a reason to be very cautious.

What the Fed is not acknowledging, and in my view mistakenly so, is that Fed policy and Fed communication affect financial markets. The more dovish tone coming from the Fed earlier in the year played an important role in stabilising conditions in financial markets. The more hawkish recent tone has already contributed to some changes in the opposite direction. Volatility indices on equity markets have moved to the top of their trading ranges of the last couple of months and currencies of emerging economies have started to weaken.

This is a pattern I have highlighted before. US monetary policy does not only affect the US economy, it affects all US dollars in assets and in liabilities around the world. Conditions outside the US continue to be vulnerable and higher US-dollar interest rates could easily lead to problems and volatility on financial markets and in emerging economies, which will affect the US also. The Fed is caught in a catch-22 situation.

How can the Fed be freed?

There are several ways this situation may be ended. First, the Fed could simply focus on domestic economic conditions, ignore market expectations and raise rates, perhaps as early as June or July. I think this would be a mistake as market volatility and negative developments in emerging economies would intensify and also affect the US. But the fact that I think it would be a mistake does not mean that it actually is a mistake and my view is certainly not going to play any role in the decision process. Nevertheless, while an early rate hike cannot be discounted, I do not think this is the most likely scenario.

A more likely scenario is one in which the Fed continues to wait. As economic growth continues, commodity prices sustain their recovery etc. the global economic situation will become more robust allowing US rate hikes further down the line without strongly negative effects on global financial markets and the global economy.

In any event, uncertainty is likely to persist in the run-up to the 15/16 June FOMC meeting and all Fed watchers will be closely monitoring every syllable spoken by any of the FOMC members.

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