The Fed’s dovish hold decision on Thursday set the cat amongst the pigeons in fixed income markets and sharply highlighted the challenges facing the world’s central banks given that:
(i) the post-crisis EM debt boom encouraged by advanced economies’ QE policies – BIS report that USD-denominated loans to EMs have doubled to $3 trillion since the crisis – have increased financial interlinkages and hence the global impacts of Fed tighening. And there are potential feedback effects on advanced economies via asset prices and banking sectors;
(ii) China’s issues in transitioning its economic model have a magnified global impact given its larger share in world GDP;
(iii) the Fed and other advanced economy central banks having to balance the above against the potential of thus-far dormant inflationary pressures kicking in as Phillips curves steepens at lower unemployment rates, but the can’t know for a while given the lags involved;
(iv) advanced economy central banks worry about the undesirable longer term impacts of extraordinary monetary policy and are getting concerned that they need to build room to react to future recessions (but face the prospect that a current tightening could provoke that very recession).
The Fed’s decision was very dovish because, despite only a sub-30% probability of a hike being priced, there was some expectation of the associated statement providing clearer guidance of a 2015 hike. Instead the market got was a strong focus on China/EM weakness/USD strength (surprising given that the US remains a very closed economy, notwithstanding an increase over the past 20 years) with the key sentance being “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” There were also reasonably meaty downward revisions to the dot plots (with four participants ruling out 2015 rate hikes and one provacatively advocating a rate cut), the Fed has apparently finally started taking note of declining inflation breakevens (subject to caveats in the press conference) and Yellen noted that the general tightening of financial conditions was importantin driving the decision.
Unsurprisingly, the net effect was for the market to further price out rate hikes. But the probability of a 2015 hike falling below 50% means that market pricing remains below the newly-lowered dot plots. Indeed, the 13bp fall in 2 year USTs represented over a two standard deviation rally while the 10bp fall in 10 year USTs was also significant. Interestingly, the market seems to have taken a “global bad news” view – the UST falls were driven by lower real rates and global equities fell back (despite the lower discount rate). There were also important international spillovers (with the corollary that the initial FX moves were actually relatively restrained relatuve to the FI moves):
(a) the Bund rally and fall in EA real interest rates interest rates helps retrace some of the recent tightening of EA financial conditions. I discuss in the accompanying posthow the Fed’s dovishness likely further increases the likelihood of the ECB expanding/extending PSPP in December;
(b) BoE rate hike expectations were pushed back to November 2016, which to me looks a bit excessive: a May 2016 BoE rate hike remains my modal case given the relative strength of the UK labour market and consumer confidence and the centre of opinion seeming to be coalescing on raising rates earlier to allow for a more gradual eventual path. But it’s understandable near term given that the BoE is the only other major central bank anywhere near hiking, the greater openness of the UK economy and Chief Economist Haldane continuing to produce well-timed provocatively dovish thoughts. And the recent sharp fall in US consumer confidence offers a bit of a cautionary tale for MPC getting too blasé about consumer sentiment.
There were, however, also signs that the Fed remains keen to start hiking in 2015 (recall that 13 out of 17 participants currently still anticipate doing so, but see further detail below). The market has for now downweighted relative to the Fed’s surprisingly greater focus on China. As such, and given that the market is barely pricing a 50% chance of a Fed hike by January, it could well be that the moment of reckoning when the Fed has to “shock the market”, and weigh up the likely impact on volatility, could only have been delayed. Indeed Yellen strongly rejected the idea that the Fed is approaching being unable to raise rates. So investors should likely be thinking about how to position for a rise in volatility in the months ahead.
Specifically, the more hawkish elements of the press conference were:
• Yellen stressed that recent developments had “not fundamentally altered our outlook”
• She suggested an FOMC in wait and see mode i.e it was “appropriate to wait for more evidence…to bolster its confidence that inflation will rise to 2 percent”
• She confirmed that both October and December are live meetings and reminded journalists that a press conference can be called at short notice in October (could six weeks be a long time in financial markets and avoid end-year illiquidity?)
• She stressed that monetary policy shouldn’t be driven by near-term financial market moves – which to me smacks of worries about concerns about “Yellen put” entering the financial lexicon and concerns about damaging the credibility of forward guidance by delaying too long.
• Her comments suggest that she continues to have faith that Phillip Curve relationships mean that inflation is likely to pickup, even though FOMC cut their median estimate of the longer-run unemployment rate to 4.9%. Indeed she argued that if the Fed waited too long then they would “likely overshoot substantially our 2% objective and might be faced with having to tighten policy in a way that would be disruptive to the real economy” (ie similar to the BoE argument discussd above).
I’m substantially less convinced on the final point. The chart below illustrates that the US Phillips Curve has been pretty flat in recent years. And there’s no real evidence of threshold effects (curve getting steeper at lower unemplyment rates) unlike in previous period. A dovish interpretation is that this either supports Yellen’s focus on wider measures of labout market slack (U6) or suggests that the natural rate has fallen even more sharply than the Fed’s downward revision (or more speculatively that technological change has undermined the relationship). There are, of course, more hawkish interpretations (lags and temporary factors affecting wages and inflation).
Personally I don’t think there’s no major problems with the Fed delaying until early 2016 if worries about the international environment and associated financial market fragility continue: a few months delay for things to settle is small beer given that rates have been on hold for nearly a decade and already tighter financial conditions are substitute for Fed tightening; there are definite risk-management benefits of doing so given the Fed’s role in thre global financial system (so this argument applies less to the BoE); if I was in the Fed I’d I’m more concerned about the loss of credibility from having to reverse a rate hike than deviating from a long-flagged plan (forward guidance was never supposed to be a promise).
Finally, the following chart is very provocative about the potential impact of China PPI deflation on US inflation – its very reduced form and subject to critiques but neveretheless suggests that the Fed doesn’t need to rush to withdraw stimulus.