Fed-watchers should focus less on Fed policymakers for guidance and more on incoming data. That, at least, was the interpretation by financial services firm Brown Brothers Harriman (BBH) of Ben Bernanke's recent Brookings Institution blogpost, in which he warned that “Fed communications have taken on a more agnostic tone recently”, arguing that a slower pace of normalization of US monetary policy is increasingly likely.
Yet scrutinizing the Fed's comments for clues about future policy has become one of the key pastimes for global economists, and it is a habit they are unlikely to kick any time soon – especially with so little clarity coming from other indicators.
“There is more diversity of opinion on the street and within the committee itself about what the Fed will do, and what it should do, about rates,” says Subadra Rajappa, head of US rates strategy at Société Générale. “This follows a long period where we have seen every good quarter followed by a bad one.”
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Subadra Rajappa, |
Amid the confusion, it is natural that analysts look to the decision makers for clues. At its recent meeting, the Federal Open Market Committee (FOMC) observed that near-term risks – financial market volatility, weak oil prices and the cloud cast by the UK's Brexit referendum – had diminished.
This, HSBC analysts conclude, “takes pressure off of the Fed to ease monetary policy to offset a potential deterioration in the economic outlook. However, it does not necessarily create conditions for the Fed to tighten policy in the near term.”
Looking at the underlying data, HSBC notes that “revised data following the latest annual benchmark revision to GDP show a clear picture of a steady softening in growth over the past year.”
GDP growth slowed to 1.2% in the four quarters ending Q2 2016, down from 3.0% in the previous four quarters. “We believe this deceleration in growth will make the policymakers at the Fed more cautious about tightening monetary policy in the near term," states HSBC.
The employment numbers have not triggered a strong response from the dollar.
Petr Krpata, an FX strategist at ING, says: “The key focus will be on chair [Janet] Yellen’s speech at Jackson Hole at the end of the month. Until then, it is hard to see meaningful USD gains against EUR or JPY.”
All about the data
Yet currency movements might not be the best place to look for clues about future interest rate policy.
“The Fed's hesitancy in lifting rates is not due to the dollar any more,” says BBH in the same research. “Rather, it is about poor data, such as the poor May employment report and disappointing GDP figures.
“The state of play is fairly straightforward. The Federal Reserve is finding it difficult to take the next step in the normalization of monetary policy. According to Bloomberg calculations, the Fed funds futures strip does not show greater than a 42% chance of a rate hike at any meeting through the end of next year.”
Société Générale's Rajappa says: “A rise in rates from 0.25 to 0.50, or from 0.50 to 0.75, is not that meaningful as far as the US economy is concerned. It is not going to make a huge difference to borrowing costs. But for the dollar, and for financial conditions, for interest-rate differentials at the front end, it is significant. That is why this is such a difficult call to make.”
The uncertainty also reflects deeper questions around the effectiveness of the policy levers being pulled by central bankers as they struggle to influence the global economy. In the UK, the Bank of England recently cut rates by a quarter of a percentage point to 0.25%, and announced an expansion of its quantitative easing (QE) programme, but doubts still remain about the impact the measures will have on growth.
To the extent that these measures are effective, policymakers are also coming to terms with the increasing prospect of the next recession starting while rates are still at rock bottom. While QE and negative rates show that the monetary tank is not quite empty, these levers are finite, and doubts about their effectiveness are feeding speculation about alternative solutions.
One possibility is an increase in the inflation target, says JPMorgan. While such a strategy looks pointless in Europe and Japan, where central banks have been unable to hit inflation targets despite easing, the US is contemplating tightening, meaning this could be a viable option.
“Were the Fed to adopt a higher inflation target now, this would lead to an immediate repricing of the path for policy rates, and likely a material easing of financial conditions,” says JPMorgan.
However, central bankers should also be looking at other options, particularly developing ways to use fiscal levers to steer the economy, says the bank, adding: “This makes particular sense if the global economy is facing secular stagnation – whereby equilibrium interest rates needed to raise activity back to its norm stand below zero.”
Although there are equally limits on the effectiveness of fiscal policy to influence the economy, greater emphasis on such tools, especially if combined with a greater degree of international coordination, would help increase inflation expectations, says JPMorgan.
In the meantime, pressure to continue monetary tightening remains, with policymakers aware that the flow of cheap money that has gushed non-stop since the crisis hit, and even before that, is distorting asset markets and punishing savers. And there is enough good news to feed continued speculation that the Fed could still hike rates sooner rather than later.
US labour market data |
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JPMorgan says: “Alone among the major developed economies, the US appears to be operating close to full employment. Wages have been accelerating across a broad variety of indicators, and even the most subdued core inflation measure – core PCE – is less than a half percent below its longer-run target.”
The labour market, arguably the source of the most positive data coming out of the US, has shown signs of strength since its spring lull, with payrolls increasing 255,000 in July. And while the latest unemployment rate for the US was unchanged at 4.9%, the participation rate picked up another 0.1% to 62.8%.
Yet even here the omens in the data are not unequivocally positive.
JPMorgan says: “If there is any rusty lining to the latest robust reading on US employment, it is that productivity growth apparently continues to languish,” with little indication of an imminent rebound. “With wage gains firming and productivity growth remaining stagnant, the underlying pressure on margins continues to be the fly in the ointment of the US expansion.”
The Fed is also mindful of the international implications of its actions. While the US is arguably ready for a rate hike, when considering the Fed's dual mandate of inflation and growth, it knows that, with the European Central Bank and Bank of Japan easing, every rise in US rates will trigger significant dollar strengthening and emerging-market weakness. It is also mindful of causing financial market volatility in coming months ahead of the US elections in November.
Slower pace of change
All this further muddies the waters of interest-rate forecasting, leading to a wide spread of predictions about Fed policy actions. The one thing analysts do agree on is that the pace of change, when it does come, is likely to be much more gradual than was envisaged last year.
UBS argues the news is good enough to “lessen worries about weak growth persisting into H2, but it does not alter their extremely gradual approach to policy normalization”. It says recent data increases its confidence there will be a rate hike at the end of the year, but does not encourage expectations of one any earlier than that.
HSBC represents the case for the doves. “We do not believe the policymakers at the Fed will want to risk hindering an already slow economy with a move to a less accommodative policy this year,” says the bank. "We expect the FOMC to wait until the middle of 2017 before raising the target range for the federal funds rate by 25 basis points.”
Société Générale also expects the Fed to hold off from any tightening this year, and to make only two quarter point rises in 2017 – as long as growth is strong in the second half of this year.
BNP Paribas, on the other hand, sounds a more hawkish tone, stating: “Data and Fed communication in the weeks ahead will encourage an increase in pricing for a September hike and we remain constructive on the USD accordingly.”