The Federal Reserve, it seems, is still waiting for the economic equivalent of perfection and risks squandering a good opportunity to begin normalizing interest rates.
While this may be part of a well-intentioned effort to prepare the ground for investors and avoid a market shock when the increase finally comes, every delay only further reinforces unrealistically dovish expectations.
Stocks rose ahead of the Fed’s decision on Wednesday, in true Pavlovian style, as even the most inattentive equity long must by now have grasped that pre-FOMC trading days are usually the most upwardly biased. The dogs had their reward when the Fed came out with no change in policy and an equivocal statement giving plausible cover for waiting several months before any hike in rates.
The S&P 500 rose by 0.73% on the day.
The Federal Open Market Committee said “economic activity has been expanding moderately in recent months,” while dropping an earlier reference to activity having changed little in the first quarter. The FOMC upgraded its assessment of labor markets but chose to look through recent further declines in energy and commodity prices, calling them “transitory” and anticipating that their effects will “dissipate”.
All of that seemed reasonably hawkish, and on its own might have primed the market for September action, but for the insertion of the world “nearly” in front of “balanced” when describing the upside and downside risks to the Fed’s mandates.
That implies that more evidence will need to be seen before a hike can come, a position which in itself ignores the trend of data which has been quite positive, especially on the labor side of the equation.
To be sure, there are two employment reports yet to come before the September FOMC meeting, but on the whole the market is still not positioned for a hike then.
“The Fed is taking baby steps towards a rate hike. Enough improvements have been made in the labor market that the Fed only needs a little more confirming evidence to say it’s time,” said Brian Jacobson, chief portfolio strategist at Wells Fargo Funds Management.
“The Fed is doing a good job getting people ready for a rate hike before year’s end, making it likely to be a low-impact event.”
Telling it like it is
Baby steps indeed, or holding a rather aged baby’s hands as it stumbles towards what is likely to be a lackluster year in riskier financial instruments.
All of this reminds me of nothing more than the tendency among parents to over-praise children on the theory that frank criticism is likely to undermine confidence. This instead sends the unwise message, and this may be what the market is doing to investors, that nothing less than perfection is tolerable, or instead that anything less than perfection from the economy requires parental support or remedial monetary policy.
It isn’t just that this will tend to encourage investors to take on too much risk (anyone remember that Petrobras 100-year bond?), it is also that the jolt when rates must eventually rise will be worse.
The real risk is that the Fed has not been frank enough about the possibility of a September hike.
“All else equal, the next two labor reports will factor strongly into the Fed’s decision in September,” University of Oregon economist and Fed watcher Tim Duy writes.
“A continuation of recent labor trends is likely sufficient to induce them to pull the trigger. Further signs of stronger wage growth would make a September move a certainty.”
So then, if we get the jobs data we should reasonably expect, we’ll get a hike soon; just a bit better than expected and rates go up in six scant weeks.
Note that fed funds futures, which allow investors to bet on when rates will rise, were utterly unchanged on Wednesday for all meetings through December. If the Fed thinks it is preparing the market, then it is preparing the market for more very low interest rates.
So what happens if the Fed catches the market unprepared and must change tack between now and September to prepare the way for the first hike?
One easy predication is that there will be a sharp uptick in volatility, a reasonably steep sell-off in riskier assets and bleats about a regulatory-induced lack of liquidity.
Next Friday’s employment report, if it is strong enough, might give us a first look.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
