Fed Preview: What You Need to Know

The Federal Reserve meeting is the highlight of the week.  The most pressing issue is the continued evolution of its forward guidance that will maximize the room to maneuver.  Until now officials have indicated that they are in no hurry to begin raising interest rates.  They have offered investors word cues of its intent. 

First the Fed indicated that there would be a considerable period between the end of the long-term asset purchases and the first rate hike.  When pressed, Yellen defined this as around six months.  Then at the end of last year, the Fed dropped this in favor of being patient.  When pressed, Yellen defined this as a couple of meetings.  The Fed repeated that in the January statement.  That seemed to signal not change in rates at the March or April meeting.  So far so good. 

In her Congressional testimony last month, Yellen suggested that the Fed’s patience was drawing to a close, but the removal of this guidance would not signal an immediate hike.  Rather it would signal that the Fed would decide on a meeting-to-meeting basis.  This would seemingly complete the Fed’s transition from a date-dependent approach to where it wants to be—data-dependent. 

An April rate hike remains unlikely.  A couple more months of improvement in the labor market may be necessary to solidify consensual action.  A number of Fed officials have identified June as a likely time frame.  The market has come to expect a change in forward guidance or policy to be announced at a meeting at which there is a press conference scheduled.  This gives Yellen the opportunity to frame the issue for investors.  It is an exercise in communication.

Of course, a press conference can be called any time, but calling an impromptu press conference would be a tell that would not be lost on market participants.  The only way around this is for the Fed Chair to hold a press conference after every meeting, like the ECB and BOJ.  We are under the impression that there are such internal discussions being held.

The Federal Reserve has identified two prerequisites for a rate hike.  First, it wants to see continued improvement in the labor market.  This improvement is understood broadly and not simply limited to the unemployment rate.  Second, the Fed needs to be confident that over the medium term the core PCE deflator will move toward its 2% target.  

The FOMC statements have recognized continued improvement in broad labor market measures.  It has also expressed confidence that inflation will rise in the medium term.  In effect, the prerequisites have been met.  This demonstrates the Fed’s patience.   Being confident that its mandates are being approached is the first reason the Fed will raise interest rates.  We expect the first hike to be delivered in June, but recognize a risk that it is delayed until September.

The second reason we expect the Fed to hike rates is that is what it has indicated.  This speaks to the Fed’s transparency and credibility.  The way the Fed conducted the tapering set the precedent.  It said what it was going to do, and it did it.  Full stop. 

The third reason to expect a hike is that Fed officials want to reactivate orthodox monetary policy tools, which it does not have the Fed funds rates is for all practical purposes still at the zero-bound emergency setting.   A new shock could only be addressed by another round of long-term asset purchases.  Officials want to avoid that if possible. 

Before the Great Depression, the end of business cycles were called crisis and panics.  After the Great Depression, policy makers and economists wanted to distinguish that profound experience.  They came up with a new lexicon—recession.  Moreover, contrary to what passes a conventional wisdom, there is no agreement that two consecutive quarters of falling GDP defines a recession.  This definition is not used to mark the US recessions officially.  The NBER, the official arbiter uses a broader definition. 

The point is that long-term asset purchases are associated with an emergency.  The downturn of a business cycle need not be an emergency, requiring unorthodox measures.  While the size of the Federal Reserve’s balance sheet will remain swollen for years to come, officials hope they can avoid making central bank’s balance sheet the go-to policy response. 

There are three main arguments against a Fed hike.  Low inflation, appreciating dollar, and the fact that most of the rest of the world is easing policy.  Currently, core inflation is indeed low.  However, there are a few mitigating factors.  The decline in energy prices is spilling over into the core measure.  This will drop out of the base effect later this year.  Fed policy has to be forward looking, and this is only made more difficult by the unpredictable lag and lead time.  In addition, if pressed hard enough, most economists, including those conducting monetary policy, embrace some version of the Philips Curve which essentially argues that a tight labor market will boost inflation over time.  Judging from the surveys, long-term inflation expectations remain broadly stable 2,5%, 

The dollar is appreciating and at a faster rate than nearly everyone expected.   Part of the rise can be explained by the relative strength of the US economy.  Part of the rise can be accounted for by the anticipation of the Fed raising interest rates.    Owing to the US limited exports (less than 15% of GDP), the dollar’s impact on the US economy is rather less than more open economies where the external sector is much larger share of GDP.  On real broad trade weighted basis, the dollar’s appreciation may shave around 0.5% off US GDP.  However, this is offset by the decline in oil prices. 

It is often remarked that foreign-generated revenues accounted for a little less than 50% of S&P 500 sales.  What is rarely noted is that because US multinational companies have pursed a foreign direct investment expansion strategy rather than an exported oriented, US companies also incur substantial local currency liabilities.  The latest comprehensive data is from 2012.  The affiliates of US multinationals hired 5.8 mln foreign workers and had a wage bill of $455 bln.  They also spent another $48 billion on research and development abroad. 

In addition, US companies have been issuing euro-denominated bonds at a large interest rate savings over dollar borrowings.  They can, if desired, swap those euros into dollars cheaper than dollars can be raised in the first place.  This is precisely what many are doing, but the cost savings are rarely included in assessing the impact of a strong dollar on corporate earnings.

The early and aggressive response by US policy makers to the crisis compared with most other countries has produced a relatively better outcome than other high income countries.   The de-synchronized business cycle requires a de-synchronized monetary policy.    US monetary policy must be conducted based on the domestic economic considerations.  The best thing for the world is for the Federal Reserve to facilitate a strong and balanced US economy. 

Lastly, we turn to Fed-watching itself.  We make three points.  First, the FOMC statement itself has a higher signal to noise ratio that the FOMC minutes and dot-plots.  It is the clearest expression of the views of the Fed’s leadership.  Second, the Fed statement clearly recognizes that the terminal Fed funds rate in this cycle will be lower than past cycles.  Market participants expected the Fed funds rate to peak between 2.00% and 2.50%.  Third, many observers still do not appear to have registered that the FOMC is not targeting a fixed rate as was previously the case.   Yet the FOMC statements are clear that the Fed has adopted a target range.  Currently, the target range is 0=25 bp.  That means that the first hike will life the Fed Funds target range to 25-50 bp.