Are we there yet? A Fed move this week looks finely balanced
There’s no doubt about the importance investors are placing on this week’s Federal Reserve rate meeting given how many column inches have been devoted to it since the last meeting in July.
So far this year the US central bank has downgraded its growth forecasts for this year twice already, at the March meeting and the June one, in the process pushing back market expectations of a possible rise in interest rates.
While the Fed left its inflation forecast unchanged in June it did downgrade it in March, so any further updates to it this week are likely to be closely scrutinised.
We also saw at the June meeting that a number of policymakers expected to see at least one and possibly two rate rises before the end of this year, according to the median "dot plot" chart projections of the Fed funds rate.
While this still remains a possible outcome, setting out ones stall on the basis of these "dot plots" in the past few years would have yielded a number of false signals.
That’s why they have never been a reliable guide to the glide path of rates in recent years, and it could be argued are the equivalent of licking ones finger and putting it in the air to test the wind direction.
Having seen the March and June meetings come and go with no rate rise, the big question this week is “are we there yet”?
On the basis of the economic data in the US, particularly on the jobs front there is an argument that the US economy could withstand a small rise in the Fed Funds rate. As things stand the two year treasury yield has been consistently above 0.6% since the end of June, so we’ve already seen a significant tightening in money market rates since the beginning of the year.
This has also been reflected in the rise of the US dollar over the last nine months, with a 7.5% rise, and up over 18% since the beginning of 2014, against a basket of currencies.
This rise in the US dollar is also what prompted China to loosen the trading band against the yuan given that the US dollars strength had seen a similar strengthening in the Chinese currency, in the process causing the world’s second biggest economy to slow down, prompting concerns that it could miss its 7% GDP target.
While the US labour market has shown consistent gains this year, the same cannot be said for price inflation and this is the other component of the rate rise narrative that is a significant cause for concern.
The US central bank has a dual mandate to target unemployment and prices and while it can be argued that it is meeting its employment mandate it isn’t meeting its inflation target of 2%.
As if to reinforce concerns about declining inflation the Reuters CRB index is down 30% in the last twelve months alone, which would appear to suggest that inflation pressures are likely to remain benign and possibly a drag for some time to come.
Muddying the waters further with respect to a rate rise has been a significant cooling in some of the rhetoric of some FOMC members in recent weeks, most notably the New York Fed’s Bill Dudley who said that a September rate rise was now “less compelling”.
With the Bank for International Settlements, the central bankers central bank, warning at the weekend that the recent market ructions could get worse in the event of a US rate rise it would be an extremely brave FOMC that took a decision to raise rates at a time when offshore borrowing in US dollars is at a record $9.6trn, and even a tiny move in rates could trigger significant short term instability, particularly in emerging markets.
This is what the Fed needs to weigh up this week as we look towards Thursday.
Does it ignore what is going on in the global economy, and the warnings of the IMF, World Bank and BIS, and act on the basis of US data alone, or does it err on the side of caution and wait to see how recent events in the global economy play out with a view to keeping its options open for October, and/or December?
Against this backdrop it is hard to see why the Fed would risk taking action on Thursday, though it will no doubt keep its messaging consistent with respect to a possible rise later this year.
Any adjustment to the growth and inflation forecasts will also be closely analysed, and in the event of no action we can look forward to the continuation of this particular bandwagon for yet another few weeks.
If on the other hand we do get a rate rise we could see a short term spike in the US dollar, but in a classic case of “buy the rumour sell the fact” any upside is likely to be constrained by a dovish message, sending the US dollar back towards its recent lows.
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