There’s a roughly one-in-three chance the Federal Reserve hikes later this month and, guess what: the stock market won’t like it.
Friday’s selloff in the Dow Jones industrial average of 272 points, or 1.66%, was analogous to a three-year-old threatening to run away from home. What comes later, as the Fed hike dawns on the market’s young mind, is an old-fashioned “throw your toys out of the playpen” tantrum.
The market will do this, of course, because it has the desired effect.
The numbers on Friday, while including a below-consensus 173,000 headline job creation number, did very little to disturb the picture of an economy creating jobs at a sufficient rate to raise employment and wages; in other words, one ready for interest rate normalization.
Stephen Lewis, economist at London’s ADM Investor Services International, wonders to what extent Janet Yellen will recall the advice of famed child-rearing expert Dr. Benjamin Spock, who counseled that giving into tantrums only brings on more.
“If they do not move, there will be a strong implication, which markets are likely to be quick to draw, that they are taking extraneous factors into account when reaching their policy-decisions,” Lewis said of the Federal Open Market Committee in a note to clients about an hour before the jobs data was released.
“That could generate even more volatility in financial markets than has been seen already this year. Market participants, in that event, are likely to conclude that the FOMC has forgotten the guidance of Dr. Spock and is driven by fear that the infants, if not assuaged, could wreck the nursery.”
So while the headline figure was light, revisions to previous months were positive and we are in the 59th month of the longest (by some margin) run of job creation on record.
Wage gains too were up at a quickening pace, rising by 0.3% for August, while June and July figures were also upgraded. Unemployment fell to 5.1%, a figure that underscores just how extraordinary the Fed’s administration of extraordinary monetary policy is.
Consider that just in June the Fed was forecasting that unemployment next year would be between 4.9% and 5.1% and would not get below 5.2% in 2015. While still in the middle of the Fed’s projection of where unemployment can be and not spark inflation, we are two-tenths of a percent off the danger zone.
This simply doesn’t look much like an economy that requires zero rates and a US$4trn central bank balance sheet.
Weight and counter-weight
Beyond the health of the economy as observed in U.S. data there are two sets of counterweights here. One is the tension between what markets will do, and its knock-on effects for the economy, and Fed policy. The second is the tension between the right policy for the United States now and the impact that will have on the rest of the world, particularly emerging markets.
Both are genuine considerations for the Fed in that both can create feedback effects that have an impact on the targets the Fed is mandated to work toward.
There is a genuine risk of financial markets selling off in a disorderly way when the Fed’s move dawns, either in reality or imagination. There is too a decent chance that tighter money out of the United States will cause emerging markets, already in something like a crisis, to degenerate in a worrying way.
Yet not everyone outside the United States will be hurt by a Fed tightening. From the point of view of the Bank of Japan and European Central Bank, a hawkish Fed may pay benefits by weakening their own currencies.
In addition, China’s rebalancing act, successful or not, will go on not for months but for years. Until its ructions hit U.S. data hard, it is not good to make policy with that threat in mind. Making Fed policy so as to neither upset financial markets or drag down emerging nations is a self-imposed hamstring.
Moving ahead to the FOMC meeting concluding September 16, it is fair to see it as a nearly 50/50 proposition. The Fed could move later in the year, possibly with an extra press conference to explain themselves. Conversely they could go ahead, and if they do, doubtless will try to hose down markets with soothing words about the deliberate, halting progress they intend to make toward normalization of interest rates.
If they do go, and they should, markets will sell off and emerging markets will suffer. But the Fed will have taken the first step toward regaining its long lost upper hand in the nursery.
(At the time of publication James Saft 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)
