The idea that the Federal Reserve stands as a kind of unpaid insurance agent to investors faces a stern test this week.
With the Fed signalling four rate hikes this year but the market betting there will only be one, the US central bank faces two-way pressure when it announces policy after its meeting ends on Wednesday: to show that it is aware that things have changed, perhaps for the worse, in the opening weeks of the year, while keeping its options open and its power respected.
Investors will be hoping for confirmation of the “Fed put,” the concept that it will ease conditions when investors face losses and volatility. Worries about slow growth and debt in China, as well as slowing global trade, have hit global financial markets hard, sending US stocks to their worst January ever, down 7%.
Certainly there is a growing disconnect between what Fed projections indicate and how markets are pricing their likely moves. Futures prices now indicate a 70% chance that the Fed either keeps rates unchanged or hikes by 25bp once this year, according to data from CME Group, an outcome given less than a 1-in-3 chance a month ago.
“Officials will probably want to acknowledge the extra uncertainty raised by recent ‘financial and international developments,’ but they will likely also want to avoid encouraging the perception that a relatively modest bout of risk aversion in markets or mixed signals from the data will promptly change their outlook in a major way,” Jim O’Sullivan of High Frequency Economics wrote in a note to clients.
Unless you are looking for a loan to do some fracking in North Dakota, financial conditions in the US are not particularly tight. Mortgage loans are inexpensive and the market for college and auto loans both seem to be making optimistic assumptions about the market for aged cars and more skilled workers six or seven years from now.
Therefore it would be hard for the Fed to build much of a case for turning more cautious based on financial markets. They have a quasi-mandate to maintain financial stability, but what we have experienced looks like nothing more than an appropriate re-pricing of risk in light of falling commodity prices and sagging inflation.
Global matters
To say the Fed touched off this re-pricing in December when it raised interest rates for the first time in a decade is not to say that it is for them to restore the old status quo. An enterprise that is imperilled by interest rates of 0.50% rather than 0.25 is one which was probably doubtful anyway.
What we are likely to see then is two things: one an acknowledgement of the international situation and secondly, a nod to declining inflation expectations.
When the Fed surprised markets in September by not hiking it made reference to international developments, which was broadly taken to mean the market turmoil in China.
There is both justification and danger in the Fed citing China as pretext for caution about interest rates. Surely ebbing Chinese demand is helping to suppress commodity prices, dealing difficulty to emerging market economies and those who mine and drill. That’s a real negative for global and US growth.
Yet China is a problem which is highly unlikely to be resolved anytime soon, both in terms of its market stability or its long-term transition to domestic consumption, so if the Fed talks about “global” issues too much it somewhat takes its own initiative away.
Both Bill Dudley of the New York Fed and James Bullard of the St Louis Fed have remarked in the past two weeks their concerns that inflation expectations are drifting further below the Fed’s 2% target. Market-based measures showing where investors bet inflation will be over the next five years are very close to all-time lows. Arguments that markets are distorted by hedging activity are undermined by the fact that surveys of consumers also show they expect quite low inflation, not just this year, but over the next five or 10 years.
That’s disturbing, but again perhaps low inflation is simply a problem the Fed and the rest of us will have to live with.
While the evidence that the Fed does go out of its way to keep investors cheerful is fairly strong, what is a lot less clear is if this is a sustainable or successful approach to managing interest rates.
The “Fed put” may be one of those muscles which gets weaker if you overuse it.
(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)
