With global financial markets reeling in the wake of Brexit - Britain's unforced error as a political gamble went too far - the Fed is back on the sidelines. A July hike was already out of the question before Brexit, while September was never more than tenuous, depending on the data falling in place just right. Now September has moved from tenuous to "what are you thinking?" Indeed, the debate has shifted in the opposite direction as market participants weigh the possibility of a rate cut. The Fed is probably not there yet, but internally they are probably increasingly regretting the unforced error of their own - last December's rate hike.
The primary economic challenge now is the uncertainty created by the British decision. No one knows what the ultimate end game will be, and how long it will take to get there. Indeed, given the political vacuum in the UK, it appears that pro-Leave politicians really had no plan because they never thought it would actually happen. At lest partially in consequence, any exit promises to be a long process that if recent European history is any guide will prove to be repeated games of chicken between the UK and the EU.
So uncertainty looks to dominate in the near term. And market participants hate uncertainty. The subsequent rush to safe assets - and with it a tightening of financial conditions - is evident in plunging government bond yields and a resurgent dollar. The Fed's initial response was a fairly boilerplate statement:
The Federal Reserve is carefully monitoring developments in global financial markets, in cooperation with other central banks, following the results of the U.K. referendum on membership in the European Union. The Federal Reserve is prepared to provide dollar liquidity through its existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for the U.S. economy.
More direct action depends on the length and depth of the financial turmoil currently underway. I think the Fed is far more primed to deliver such action than they were a year ago. And that ultimately is good news for the economy as it will minimize the domestic damage from Brexit.
The Fed began 2015 under the direction of a fairly hawkish contingent that viewed rate hikes as necessary to be ahead of the curve on inflation. Better to raise preemptively than risk a sharper pace of rate hikes in the future. In other words, it was important to remove financial accommodation as the headwinds facing the economy receded and labor markets approached full employment. As the year progressed, however, the need for less financial accommodation never became evident. Indeed, I would argue that asset markets were telling exactly the opposite, that there was far less accommodation than the Fed believed. Fed hawks were slow to realize this, and, despite the financial turmoil of last summer, forced through a rate hike in December. I think this rate hike had more to do with a perceived need to be seen as "credible" rather than based in economic necessity. I suspect doves followed through in a show of unity for Chair Janet Yellen. They should have dissented.
Markets stumbled again in the early months of 2016, and, surprisingly, Fed hawks remained undeterred. Federal Reserve Vice Governor Stanley Fischer scolded financial market participants for what he thought was an overly dovish expected rate path. And even as recently as prior to the June meeting, Fed speakers were highlighting the possibility of a June rate hike, evidently with the only goal being to force the market odds of a rate hike higher.
But I think that as of the June FOMC meeting, the hawkish contingent has been rendered effectively impotent. Simply put, had they been correct, the US economy should have been surging ahead by now, with more evident inflationary pressures. The hawks were far too early with such a prediction. It became increasingly apparent that maybe the yield curve was telling an important story they should heed. Low long-term yields were never consistent with the Fed's outlook, and, when combined with tepid activity, suggested that the Fed's long-term guide, the natural rate of interest, was much lower than anticipated.
Consequently, I suspect the Fed will be much more responsive to the signal told by the substantial drop in long-term yields that began last Friday (as I write the 10 year is hovering about 1.46%) then they may have been a year ago. The drop in yields will feed into their current anxiety about the level of the natural rate of interest, and as a consequence they will more quickly realize the need to accommodate financial markets to limit any undesirable tightening of financial conditions. I expect some or all of the following options depending on the degree of financial market and real economic distress:
1.) Forward guidance I. Fed speakers will concur with financial market participants that policy is on hold until the dust begins to settle. Optimally, they will dispense with all talk of rate hikes as it is unnecessary and unhelpful at this juncture.
2.) Forward guidance II. They will reinforce point I in the next FOMC statement. Watch for the balance of risks to reappear - it seems reasonable to believe they have shifted decidedly to the downside.
3.) Forward guidance III. This would be an opportune time for Chicago Federal Reserve President Charles Evans to push through Evans Rule 2.0. No rate hike until core inflation hits 2% year-over-year. The Fed could justify such a move as a response to the uncertainty surrounding the natural rate. Essentially, rather than using an unknown variable as a guide, use a know variable.
4.) Forward guidance IV. A lower path of dots in the next Summary of Economic projections to validate market expectations.
5.) Rate cut. Former Minneapolis Federal Reserve President Narayana Kocherlakota argues that the Fed should just move forward with a rate cut in July. I concur; I continue to believe that the Fed has the best chance of exiting the zero bound at some point in the future by utilizing more aggressive policy now. That said, I don't expect this to be the Fed's first option. Moving beyond forward guidance will require evidence that the US economy is set to slow sufficiently to push the employment and inflation mandates further out of reach.
6.) If all else fails. If some combination of 1 through 5 were to fail, the Fed will turn to more QE and/or negative rates. I think the former before the latter because it is more comfortable for them.
Bottom Line. The Fed will stand down for the moment; where they go down the road depends upon the depth and length of current disruption. I think at this point it goes without saying that if you hear a Fed speaker talking about July being on the table or confidently warning about two or three rate hikes this year, you should ignore them. Perhaps we can have that conversation later with regards to the December meeting, but certainly not now. Most Fed officials will stick to the script and downplay the possibility of a rate hike and instead focus on the Fed moves to the sidelines angle. I still think an interesting scenario is one in which the Fed needs to accept above target inflation because global financial stability will depend on a very accommodative Federal Reserve, but that hypothesis will only be tested once inflation actually hits target.
