Going into the September FOMC meeting, it was pretty clear that the Fed was boxed in.
Beijing’s August 11 “surprise” deval had exacerbated an already precarious situation for EM, characterized by depressed demand from China, slumping commodity prices, and the incipient threat of a Fed hike. The risk for Janet Yellen was that hiking would cause a kind of super taper tantrum, accelerating EM capital outflows and exacerbating the EM FX bloodbath.
On the other hand, it was also possible that by continuing to delay liftoff, the Fed was contributing to uncertainty in the emerging world and that uncertainty was actually contributing to the very same outflows the Fed feared a hike would trigger. That is, the argument was that it’s not a symbolic 25 bps hike that EM fears, but rather being left constantly in the dark about when or even if the FOMC plans to move.
As you can see, that’s a Catch 22. Hike and risk triggering an EM meltdown as the dollar soars, or don’t hike, and risk creating still more uncertainty and thereby contribute to continual, if less acute, flows out of EM (call it “death by a thousand non-cuts”).
And then of course there were domestic considerations (in fact, it wasn’t until September that the Fed conceded that the reaction function had changed to include international financial developments). Hiking would telegraph the Fed’s confidence in the US economic “recovery” but would mark the beginning of the end for “punchbowl” policy (if you will). Not hiking would signal that the Fed is prepared to let the party go on for a while longer but would suggest that the committee is worried about the prospects for the economy.
Importantly, the domestic reaction function isn’t compatible with the international reaction function given the current environment. We discussed this in detail in September in “When Doves Cry: Bedeviled By Dollar ‘Dilemma’, Trapped Fed Faces FX Catch-22.” Here’s what we said:
The Fed has to choose between keeping a lid on USD strength by staying dovish, or resurrecting domestic risk appetite by telegraphing more confidence in the economy.
And here we see how the Fed’s new reaction function has immeasurably complicated things. That is, in order to keep from exacerbating EM market turmoil, the Fed was forced to lean dovish. But by doing so, it caused risk to sell off at home which, as Goldman notes, “is obviously the opposite of what the Federal Reserve wishes to accomplish.”
The only way to counter that undesirable outcome is to talk up the economy and accept dollar strength but then that’s exactly what the Fed was trying to avoid doing in September because the committee knew it would trigger an EM meltdown. The new reaction function seems to involve sensitivity to both domestic andglobal 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.
Now that Mario Draghi has signaled that the ECB is set to plunge further into the monetary Twilight Zone in December (and we know Haruhiko “Peter Pan” Kuroda is always ready to pull the trigger if “necessary”), and now that the situation seems to have “stabilized” in China (and by “stabilized” we mean capital outflows were only around $30 billion in October inclusive of freshly-entered forwards), the Fed is free to lean hawkish again which is what happened with the October statement even as the minutes (out yesterday) suggest the FOMC would ease more further down the road should things deteriorate (which they will).
So that’s the complete rundown of what has become an impossibly convoluted situation that now requires the Fed to essentially fly by the seat of their pants, conducting policy in an ad hoc manner from meeting to meeting.
Note that what's not mentioned above is actual US economic data. That's on purpose. Put simply, the idea that the Fed is "data dependent" went out the window long ago and with that point in mind, we take a close look at a new note from BNP who thinks the Fed has missed its window essentially because they aren't very good at forecasting or interpreting economic data and even if they were, it's not clear they would act accordingly. This has led the FOMC to commit a possibly dangerous policy “error.”
“One of the frequent client questions we hear is, ‘Is the Fed about to commit a policy mistake?’”, BNP begins, noting that clients are apparently concerned about whether the FOMC is hiking too early.
For the bank, “the answer is ‘yes’”, but not because the Fed is hiking too soon, rather because they are hiking too late. Here’s how BNP defines “policy error”:
A monetary policy mistake occurs when a central bank sets policy that is inappropriate for the underlying and prospective economic circumstances of the time and when the consequences of this prove to be significant deviations of growth and/or inflation from desired outcomes.
Ultimately, BNP thinks there are all kinds of reasons to believe that the Fed failed to recognize when the economic circumstances were right for a hike and the consequences will ultimately be a recession.
As the bank puts it, “the reason for our recession concern is not so much because of what the Fed is about to do – likely embark on a slow hiking cycle beginning in December – but because it did not start the tightening much sooner.”
If we assume a ~1.5% nominal equilibrium rate, we’ll hit zero real Fed funds sometime in H1 of next year assuming the Fed hikes in December and moves every other meeting. In the interim, with rates below equilibrium, unemployment may continue to fall. The problem: if unemployment undershoots, the snap back would almost invariably trigger a recession. Here’s how BNP described the situation:
Chart 3 shows various rule-based estimates of where the fed funds rate should have been and where it should be right now. If we assume real fed funds should be zero, then with a zero output gap, nominal Fed funds should be about 1.0%, according to the Taylor Rule. However, it is 0.12%. This suggests policy tightening has started later than a rule-based approach would suggest. This may be for good reasons – asymmetric risk, for example. But the policy rate is still below equilibrium and is a good explanation of why growth continues above potential (as is demonstrated by an almost continuously falling unemployment rate).
Here’s a problem. New York Fed President William Dudley recently pointed out that whenever the US unemployment rate has increased by more than 0.3-0.4pp from its low, there has always been a recession (Chart 5). Knowing this, it is perhaps not surprising that the median Fed forecast always shows the unemployment rate levelling off close to its equilibrium. The Fed would presumably be reluctant to forecast that its actions (or lack of them) would cause an undershoot in the unemployment rate, which would more than likely end in a recession.
The bank then proceeds to discuss inflation dynamics and while there’s some good color there, we’ll boil it down to two simple passage for the sake of brevity: “Core PCE has been drifting down as unemployment, a proxy for economic slack, has been falling. It is tougher to discount survey evidence, where the survey of professional forecasters and the Michigan consumer survey are flashing warning signs that inflation expectations are slipping [and] we are not convinced it is wise for the Fed to brush off such warning signs and carry on claiming inflation expectations are stable, because they’re not.”
Summing up, BNP says “this is another example of the Fed having passed up its best opportunity to hike rates – last year when the economy was rattling along with a long string of strong payroll data, when manufacturing was less of a drag on the economy, when emerging markets looked sounder, oil prices were higher and when US monetary and financial conditions were a lot softer than they are now (mainly because of the exchange rate).”
And here’s the bank’s bullet point summary:
- The Fed has left hiking rates until the unemployment rate is 5.0%. This is very possibly too late to be able to achieve a soft landing;
- The Fed looks like it will be hiking when inflation expectations are on the slide, which a hiking cycle can only intensify. Real rates will be higher than if lift-off had come in 2014;
- The current unemployment rate is virtually at the NAIRU and could well be below it if we take into account the behaviour of real wages;
- The Fed wants to hike slowly, meaning that above trend growth will continue for a while;
- Given current labour market dynamics, the unemployment rate is likely to trough well below the NAIRU. To stabilise the inflation rate, the Fed may have to raise the unemployment rate by at least a half a point.
- Soft landings are next to impossible to achieve and, whenever the unemployment rate has risen by more than 0.4 pp from its lows, there has always been a recession.
So in addition to all of the other reasons we have to predict that the US is either already in (just ask Fastenal's Dan Florness) or about to enter a recession, we can add "Fed policy mistake" to the list, and on that note we'll close with one last quote from BNP:
...the lower the unemployment rate goes, the greater the chances that this will end in recession, further disinflation and a return to zero rates. The mistake may not be in the future, but the past.