This Thursday the Fed may or may not hike: either outcome has become a losing proposition. If the Fed hikes, the market will tumble (regardless of the initial PPT and algo-driven spike designed to set the mood that this is the "right thing to do") after the Fed unleashes the next step in the Emerging Markets currency crisis, and the Chinese hard landing goes global. If the Fed does not hike, it will admit all its caveats about data-dependency (in an economy with 5.1% unemployment and a record high number of job openings) was nothing but a lie, and again expose itself as a muppet of the wealthiest market participants.
In other words, perhaps more than concerns about the market's reaction, the Fed may be just as worried about losing any more credibility with a global market where QE has increasingly less impact.
But is it?
As RBS summarizes it, "the Fed’s dilemma is a trade-off between shaking the tree today, risking that volatility and capital flight in EM may ‘spill-back’ into developed economies, or waiting and watching the fault lines deepen. Claudio Borio uses some economist humour to describe the issue: “All this is reminiscent of the old joke about the stranded tourist who, having asked for directions, was told: "If I were you, I wouldn't start from here."
What should the Fed do?
The choice is tough, and major policymakers are telling Janet Yellen to hold (IMF, World Bank, Summers and others). The arguments tend to be similar, mostly, worries about inflation being persistently low. This is true: inflation is low, from a mixture of commodity downward pressures, and structural imbalances in the labour market. But the real reason to hike is another one: preventing the debt $-denominated overhangs from building up further – the burst of which would be, in turn, even more deflationary (and the same imbalances resulting from a financial boom can also reduce productivity, as discussed by the IMF). So if the Fed’s mandate is to worry about the medium-term and to target structural issues vs today’s asset prices, the right thing to do would be to hike. This is also what the majority of institutional investors think. But the Fed won’t.
Why not? It appears that the Fed no longer cares about doing the right thing for a very simple reason - the Fed no longer is worried about losing credibility. As the following chart showing the results of a survey of 150 institutional RBS clients and investors confirms, two -thirds already believe the Fed has lost credibility.
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As such, the Fed's only mandate is perhaps to prove that while it may no longer have the credibility, it still has the ammunition to influence markets. Because if the latter runs out, then it really is time to panic.
