by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
· Yesterday’s FOMC meeting and press conference generated widespread unease. My personal uncomfortable feeling was reminiscent of a time many decades ago when a date stood me up and provided an excuse that made little sense. Simply put, the combination of the FOMC’s forecasts, economic assessment, and guidance on the future path of interest rates were incongruous and disconnected to their ‘data dependency’ message.
· This week was a curious time to recalibrate to a far more dovish stance since it has followed clear improvement in labor markets, inflation indicators, and inflationary expectations. Even with the modest downward adjustments to their economic projects, the Fed’s goals and mandates have not only (basically) been achieved but they seemingly have economic momentum behind them as well.
· Core year-over-year inflation measures have been rising. Core CPI rose to 2.3% earlier this week. The PCE deflator has risen to 1.7% which already stands above the Fed’s year-end estimate. The Fed once again lowered the level it believes to be its longer-run estimate of the natural rate to 4.8%.
· Regardless, with the unemployment rate currently at 4.9%, the Fed is implying by its belief in the Philips Curve that wages will soon accelerate. Despite modest changes in the Fed’s economic projections, the Fed is forecasting growth above its estimate of potential growth. So how is it possible that a ‘data dependent’ Fed turned dovish?
· Reporters tried to address these questions during the press conference. Yellen was uncharacteristically opaque. She deflected questions. It had the appearance of a coach who had a specific game plan, but the familiar playbook was replaced on the day of the game. The market place is abuzz with two possibilities for such a shift.
· The first possibility is that something spooked the board. The market is only learning now from Bernanke’s book that QE2 and QE3 were initiated because of fears of the European crisis, not due to a shortfall in economic targets as claimed. Most people believe that the Fed deferred a hike in September due to “international developments”. Therefore, has the Fed turned dovish again due to deep-seeded international concern?
· The first possibility may have been the catalyst for the second. The second possibility being discussed is that some type of central bank accord was reached at the G20 meeting in Shanghai February 25-26. Maybe they noticed that diverging central bank policies were leading to extreme market volatility and accusations of currency wars. It is not difficult to envision an agreement where central banks agreed to provide more stimuli, if the Fed agreed to pause in order to not offset the effects of such moves.
· This would mean that the Fed would have to ignore economic data. Since markets have become more correlated, a pause would allow the dollar to weaken, and in turn, take pressure off of China to devalue the yuan. This would also help commodities to rise and emerging markets to soar. As global financial conditions begin to improve, the Fed would then have better cover under which to hike interest rates.
· These theories are certainly possible. Great global challenges and uncertainties exist and so there are many areas that could be concerning to Fed officials, but which cannot be explicitly identified as the cause of the Fed’s policy shift. What is clear is that subsequent to the G-20 meeting, there have been policy stimulus actions from the following: ECB, BoJ, PBoC, RBNZ, and the Central Bank of Sweden (to name a few).
· Central bank stimulus today is very different than stimulus during the past several years. Chasing risk assets is an increasingly dangerous game of chicken. Central bank stimulus has not had the desired economic effects, so financial valuations have diverged from economic fundamentals. Helpful regulatory and fiscal measures are nowhere to be found. At some point, policy makers have to treat root causes, rather than the symptoms with monetary painkillers.
· Negative interest rates or QE that is too aggressive can scare consumers (e.g., the BoJ reaction). I have written in the past that zero rates and QE does long-term harm, but now I believe that negative rates and QE are harmful and counter-productive in the short-term as well. A retrenching consumer during an earnings recession is not good news.
· The FOMC used to say that a hike would be “good news” because it represented great confidence that economic conditions were so good. Now the Fed wants us to believe that their dovish stance is good news as well, because it means greater levels of accommodations. It is a stretch to believe that both can be true.
· Financial intermediation between savers and investors has hints of trouble due to negative rates. A news story yesterday said that Munich Re is experimenting with storing cash and gold. The time has come to end NIRP and ZIRP, and other forms of aggressive central bank experimentation and the dangerous consequences that come with them. It time they take a giant collective BURP, I mean BIRP (Basic Interest Rate Policy).
“I bought some batteries, but they weren’t included.” Steven Wright
Guy Haselmann | Capital Markets Strategy
Scotiabank | Global Banking and Markets
250 Vesey Street | New York, NY 10281
T-212.225.6686 | C-917-325-5816
Scotiabank is a business name used by The Bank of Nova Scotia
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