Fed on horns of not-so-bullish dilemma: markets or economy?

August 25, 2015

The Federal Reserve increasingly looks stuck on the horns of a not-so-bullish dilemma: should it pay attention to global developments in financial markets, which argue for pause, or should it focus squarely on U.S. economic data, which suggest the time is nigh to hike?

In what has been a brutal start to the week for global stock markets, commodities and currencies, another delay in the U.S. Federal Reserve’s long-awaited first interest rate hike in nearly a decade is now priced into markets.

But not yet for economic forecasters.

So far only one of the economists who told Reuters, in a poll taken  a couple of weeks back, that September was the month has publicly flogged their revised view. That’s despite the fact interest rate futures have almost completely erased the likelihood of a September hike and have factored out most of a December move.

Barclays has delayed its prediction for the Fed’s first move by half a year, to March 2016.

Although we continue to see economic activity in the U.S. as solid and justifying modest rate hikes, we believe the Federal Reserve is unlikely to begin a hiking cycle in this environment for fear that such a move may further destabilize markets.

In addition to worsening financial market conditions, our decision to delay our outlook for the tightening cycle stems from the effects of a stronger U.S. dollar, lower oil prices, and weak global demand on our outlook for U.S. inflation.

We move our call to for the first rate hike from September 2015 to March 2016. Given the uncertainty around the current global outlook, the timing of the rate hike seems more uncertain than usual.

Reluctance among economists to change their view, apart from the act of having to admit the previous call probably isn’t right, at first blush seems perplexing.

Indeed, Ray Dalio, founder of the world’s largest hedge fund, Bridgewater Associates, has said the Fed’s next move will be to loosen policy, not tighten it. That follows a warning by Larry Summers that raising rates next month would be a mistake.

Compared with the last time the Fed raised interest rates almost a decade back, the inter-connectedness of financial markets has increased manyfold – and the recent developments in markets from FX to stocks to commodities would at the very least push for a pause.

Royal Bank of Canada economists wrote in a note:

The point is that the Fed is not courageous enough to hike if this is the sort of backdrop they are staring at come the September meeting—even though they have more than enough reason to from a pure economic standpoint. This is an important distinction. Monetary policy decisions are not a one variable equation based only on economic data. Financial conditions are also included.

Think of it this way, if the first Friday of September rolls around and job growth clocks in at a frothy +300k, but the equity market remains volatile over that period and in a downward trend, the Fed will not raise rates.

The after-effects of a 25 percent slump in Chinese stocks in the last week, triggered by fears the world’s second largest economy may be rapidly losing momentum, can hardly be contained to just one economy or region.

The Dow Jones industrial average fell almost 600 points on Monday, tracking the rout in China and other Asian and European stock markets.

DJIA

On Tuesday, a Wall Street rally went up in smoke, leaving the Dow with losses of more than 10 percent over the last five trading sessions, its worst five-day run in four years. The S&P 500 index has lost 11 percent over the last week.

Those losses came despite a surprise cut in both the Chinese central bank’s key rates and the reserve requirement ratio for big banks. The move provided only temporary relief and did not stop Chinese stocks from falling again on Wednesday.

If that market blood-bath continues, the Fed may choose to deploy a safety net, termed the Fed ‘put’ by markets, by delaying a rate hike.

An inflation rate that is close to zero has so far been considered as perhaps the only impediment for the Fed to hike. (Inflation isn’t much higher in China, either).

And with a strong dollar, coupled with sliding oil prices, inflation will probably drag lower for longer.

But after months of preparing financial markets for a rate hike this year, even if only a token, many remain skeptical that the Fed will pull out now.

The consensus for a hike has already shifted once this year when economists collectively moved to September from June earlier, after data showed the U.S. economy surprisingly contracted in the January-March quarter.

The economy has since stabilised, adding new jobs at a solid pace, giving Fed Chair Janet Yellen an opportunity to ‘normalize’ policy after years of zero rates and printing money.

Analysts at Capital Economics wrote:

In a nutshell, the panic has led investors to conclude that the Fed will be less inclined to tighten monetary policy in the near future. Our view, though, is that events in China are unlikely to deter the U.S. central bank from hiking the federal funds rate in September and we continue to think that it will subsequently raise the federal funds rate faster and further than most expect.

There’s still three weeks between now and when the Fed meets in September to decide policy and proponents of a rate hike next month expect financial markets to stabilise by then.

But the ride to that momentous hike, if it comes next month, looks choppy.

 (This blog has been updated to reflect the Wall Street close on Tuesday. Additional inputs from Ross Finley and Deepti Govind)

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