On Monday in “When Doves Cry: Bedeviled By Dollar ‘Dilemma’, Trapped Fed Faces FX Catch-22,” we described precisely why the Fed’s new reaction function simply can’t work given prevailing market conditions.
The Fed adopted the so-called “clean relent” precisely because it knew that the strong dollar would, as Goldman put it, “go through the roof” at the slightest sign of hawkishness. Of course a soaring dollar would likely be more than enough to send the EM world careening into crisis as China’s new currency regime and depressed commodity prices have conspired to push commodity currencies to the brink. The resulting outflows and subsequent meltdown would almost invariably feed back into advanced economies forcing the Fed to do an embarrassing about face. Unfortunately however, US investors interpreted the Fed’s move to postpone liftoff as a sign that Yellen was worried about the economy leading directly to the worst possible outcome: risk off sentiment that triggered a post-FOMC selloff. In short:
The new reaction function seems to involve sensitivity to both domestic and global financial markets. In the current environment where a positive assessment of the outlook for the US economy is required to keep a bid under risk assets (i.e. in an environment where good news is good news again) but in which EM is one "symbolic" Fed hike away from careening headlong into crisis, the new reaction function can’t possibly work.
What the above should suggest, perhaps more than anything else, is that there’s a certain reflexivity to the entire thing and it’s especially evident when we look at how the Fed got itself into the current predicament.
There’s a certain line of argumentation that says the Fed missed its window to hike and ever since, the uncertainty has only grown with each passing FOMC meeting. That uncertainty serves to perpetuate outflows from EM and now, the Fed is set to use those very outflows as an excuse for why it must postpone liftoff.
With that, we’ll close with the following concise formulation of the reflexivity problem from former Treasury economist Bryan Carter who spoke to Bloomberg:
”Short-end rates move higher as the Fed gets closer to hiking, and that causes the dollar to strengthen, and that causes global funding stresses. They are creating the conditions that are causing the external environment to be weak, and then they say they can’t hike because of those same conditions that they have created.”