Fed Watch: The Right And Wrong Arguments For September
This September meeting is the gift that keeps on giving. Right now it is giving by the shear quantity of truly bad commentary arguing for a rate hike next month.
Let's back up a few weeks. Prior to the recent market rout, September looked like a pretty good bet. And the basic story that justified that view still holds. It isn't complicated. Just a straight forward Phillips curve story. The economy continues to improve, dragging the labor market along for the ride. Any questions about the meaning of a weak first quarter GDP report were wiped away by the second quarter. Neither is by itself meaningful; the average of 2.5 percent growth for the first half is just about the same as 2014 as a whole. As the labor market approaches full employment, policymakers expect that wage growth will accelerate and they must raise interest rates to prevent those wage gains from translating into above-target inflation. They feel they need to raise rates sooner than later to be ahead of the curve.
That story is not without holes, of course. The lack of widespread faster wage growth or inflationary pressures as the unemployment rate approached the Fed's estimate of full employment should be a red flag. Moreover, measures of labor underutilization remain elevated. Marked-based inflation expectations were low and falling, the dollar was rising, and commodities were tanking. And it seems that the risks of premature exit from ZIRP still outweigh the risk of holding on just a little too long. The Fed staff highlighted this risk in the July FOMC meeting. From the minutes:
The risks to the forecast for real GDP and inflation were seen as tilted to the downside, reflecting the staff's assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks.
Despite these questions, Fed policymakers were leaning toward a rate hike in September, at least in my opinion. Fundamentally, they want to start raising rates and had shifted toward looking for reasons to do exactly that. It was never, however, a done deal, at least according to the probabilities assigned by the Fed futures markets. I was fairly confident of a September rate hike, but arguments against were entirely reasonable. I still believe that the Phillips curve story justifies expecting a rate hike in September.
Then I go on a little vacation to visit an old friend, the market starts sliding, culminating is a white-knuckle thousand point drop on the Monday opening. I saw that and came to the same conclusion as fed futures markets. A rate hike probably wasn't happening. That kind of volatility cannot be ignored, and it put the exclamation point on signs that US financial conditions tightened with the end of QE3. We have been around this block before. We know how the story ends.
As a long time Septemberist (Junist, back in the day), I was not pleased.
Many others are not pleased as well, and the commentariat is bringing forth a host of bad reasons to push the Fed into hiking rates in September. One of my favorites comes from Jon Hilsenrath of the Wall Street Journal, reporting from Jackson Hole:
Raising rates would signal that the Fed is confident about the U.S. economy, Bank of Japan Governor Haruhiko Kuroda said Wednesday in New York, ahead of the Fed gathering. “That is not only good for the U.S. economy, but also for the world economy, including the Japanese economy,” he said.
Really, the Fed needs to be taking advice from the Bank of Japan? I think you should listen to their advice and do exactly the opposite. Rushing to hike rates never did them any favors. Foreign central banks have anything but the Fed's best interest in mind. Hilsenrath knows this:
When interest rates rise in one country but not another, the currency tends to strengthen in the country where rates go up, because the higher rates offer greater returns on bank deposits and fixed-income investments.
Looser conditions abroad require looser conditions in the US, all else equal, to hold the US economy steady. Foreign central bankers, however, are looking to boost growth off of weaker currencies, and hope the Fed thinks they should just eat the consequences for the US economy. Not. Gonna. Happen.
Another anecdote from Hilsenrath:
“If you delay something that you were planning to do, then you leave the impression that your compass is different than what you led markets to believe,” Jacob Frenkel, chairman of J.P. Morgan Chase International and former head of the Bank of Israel, said in an interview Thursday. Market drama is increased by delay, he added.
No, markets know exactly what the compass is. That's why futures markets reacted so quickly Monday. Because those traders read the FOMC statements:
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.
Monday went well beyond typical volatility. The Fed could justify hiking rates if stocks were moving sideways. Or even drifting downward slowly. But Monday? Monday was something different, something that pointed to some significant fragilities in financial markets. And if you think those fragilities will lessen by higher rates, well that's just delusional.
From the New York Times we get this:
Lim Say Boon, the chief investment officer for DBS Bank in Singapore, questioned any optimism over maintaining interest rates at their current low level.“If markets are unhappy about a September rate hike, would they be happy with a December hike?” he wrote in an analyst note on Thursday. “I am not sure what ‘victory’ would look like for those in the market who are ‘rioting’ against a rate hike in September. There is also a risk of the Fed being seen as hostage to an angry mob in the market — cowed because the mob is smashing up the ‘furniture.’ ”
The precedent was the taper. Former Federal Reserve Chairman balked at tapering in September 2013, let markets digest the policy change, and then moved forward in December 2013. No problem. The stuff about "hostage to an angry" mob is code for "my trade is going sideways and I need someone to blame."
Former Philadelphia Federal Reserve President Charles Plosser offers no surprises in these comments:
“I think the Fed needs to be careful and not overreact to short-term events,” Mr. Plosser said. The Fed’s policy committee “should keep the focus on the longer term.”
I would say that Monday shocked the Fed into looking at the longer term, such as the deterioration in inflation expectations, long a favored indicator that fell out of favor because it became inconvenient:
“The less the Fed says about [the selloff] the better, because it creates the impression that monetary policy is responsible for markets, which it’s not,” he said.
Actually, the Fed is responsible for maintaining financial conditions conducive to maximum sustainable growth so, yes, monetary policy is responsible for financial markets. And those markets are how the Fed transmits policy no less. So the Fed can't just say "it's not our problem" because it kind of is their problem.
Stephanie Rhule at Bloomberg uses the Fed's flagging commitment to September to pull out a oldie but goodie:
The Federal Reserve has had many opportunities to raise rates over the last several years and—whether it was because of too many snowstorms, too few jobs, or not enough consumers hitting the malls—the Fed didn't raise. Why? Because it didn't have to. When the unemployment rate dropped to 7 percent in 2013 and 6.5 percent in 2014, many said this was enough cause to finally raise rates off the extraordinary zero bound. The Fed kept moving the goalposts and said: not just yet....For those feverishly predicting September vs. December, in terms of timing, you can scratch that concern off the list. The timing on everyone's mind is simply the fear of an additional major market fall. Wouldn't it be great if the Fed had raised rates two years ago, so it would have room to cut in the event that the economy follows the markets into a recession? Now it can't hike because the markets are a mess, and it can't cut because we are already at zero.
Really, everything would be better now if the Fed had been hiking two years ago when unemployment was 6.5%? We needed to choke off growth in 2013? Markets could barely swallow the taper by the end of 2013. In what world does anyone think the economy could have handled any level of rate hikes then that would have provided a realistic cushion now?
Rex Nutting at Market Watch uses the week's events to moralize on the "Greenspan put":
...This “Greenspan put” means investing in the stock market is a one-way bet......I believe the market selloff has made a September rate hike even more compelling than it was before, because it gives Fed Chair Janet Yellen the opportunity she needs to kill the “Greenspan put” once and for all......if supposedly risky investments like corporate equities and bonds are actually guaranteed by the Fed’s “Greenspan put,” then investors aren’t embracing risk at all...
Hmmm...I know plenty of people who don't think that investing in stock markets is a one-way bet. Like all those WorldCom investors. Or more generally anyone caught up in 2000. Or 2008. And apparently Millenials don't trust stocks, so they didn't get the message about the "Greenspan put." So let's end this now: Way too many people have lost way too much money for this supposed "Greenspan put" to be a real thing. It is more code for "my trade is going sideways and I need someone to blame."
Nutting extends his moralizing to Fed officials:
...Officials have been obliquely warning that some stock market valuations are too high to be justified by fundamentals. In truth, the correction in the U.S. markets has been welcomed at the Marriner Eccles Building. The Fed doesn’t mind the dip in the Dow, because it punishes complacency and because the selloff has been relatively orderly. There’s been no panic on Wall Street...
I don't think a guy like Vice Chair Stanley Fisher is sitting around thinking that he needs to take a chunk out of everyone's 401k just to teach them a lesson. OK, so maybe Kansas City Federal Reserve President Esther George is thinking that, but that would be a minority position.
Hey, it's been a hard couple of weeks. Things changed. That certain rate hike became alot less certain. Maybe that changes back by September 17. Maybe not. All of us Fed watchers probably won't come to agreement until September 16. Getting emotional and moralizing about change isn't going to stop it. I have learned through the years to heed the advice of a fictional financier:
Stocks dropped sharply. It is a clear sign, on top of other signs, that financial conditions are tightening ahead of the Fed, and arguably too much ahead of the Fed. If the Fed heeds that warning you have to remember that's their job. Smoothly functioning financial markets. Lender of last resort. All that stuff. Maybe things work out just fine if they don't heed that warning. I am not interested in taking that risk. Not enough upside for me.
But if they take that risk, it won't be because they want to send the markets a message that they are in charge, or that the "Greenspan put" needs to be put to rest, or that they can't been seen as cowering to the markets, or that they need to stay the course because they already signaled a rate hike, or because foreign central bankers are demanding the Fed hike rates, or because they need to build ammo for the next crisis, or any other reason that comes from barstool moralizing after one too many. If they hike rates it will be for one simple reason: The recent market turmoil does little to shake their faith in the Phillips Curve. That would be the heart of their argument. And if you are arguing for September, that should be the heart of your argument as well.
Posted by Mark Thoma on Friday, August 28, 2015 at 12:15 AM
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