The FOMC meeting came and went with the expected result – the tapering process continued on schedule, undeterred by the current emerging market turmoil. Of course, the Fed doesn’t want to be seen as reacting to every gyration financial markets. But even more importantly, the Fed wants out of the asset purchase business on the belief that a.) tapering is not tightening and b.) even if it was tightening, they could compensate via forward guidance. The global stumble, however, is challenging that thinking. Regardless of financial markets or US data, the Fed was not likely to launch into a new policy direction on the eve of incoming Chair Janet Yellen’s coronation. It’s her show now.
The statement acknowledged the better tone of the data:
Information received since the Federal Open Market Committee met in December indicates that growth in economic activity picked up in recent quarters.
while at the same time giving a nod to weak job growth in December:
Labor market indicators were mixed but on balance showed further improvement.
Inflation is low, but that is offset by stable expectations:
Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.
Upside and downside risks are equally weighted:
The Committee sees the risks to the outlook for the economy and the labor market as having become more nearly balanced.
Low inflation is an issue they are assessing, but it is not sufficiently worrisome to alter the pace of the taper:
In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in February, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $30 billion per month rather than $35 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $35 billion per month rather than $40 billion per month.
At these rates, inflation is only a deterrent against higher interest rates, not tapering.
Despite the plunge in the unemployment rate, the combination of the Evans rule and enhanced forward guidance remains unchanged:
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.
I think we can be confident that much of the conversation centered around forward guidance, but there was not quite a pressing need to end or alter the Evans rule with unemployment still above 6.5%. Moreover, any change to the forward guidance needs to be owned by Janet Yellen, and she will not have that opportunity for another six weeks. Which will not be just her first meeting as chair, but also her first press conference as chair. Trial by fire.
The Fed did not, as some supposed they might, react to sliding overseas markets. This, combined with the tempered reaction to weak job growth and the absolute abandonment of the inflation target, speaks to the Fed’s determination to end asset purchases. We will need to see the emerging market downturn lapping up more directly on US shores before the Fed reacts. The downturn in US equities is not yet enough. Not only does the Fed not react to every dip in the market, they probably would not be surprised by a correction in any event. The are inclined to believe that while not a bubble, stock prices were getting a little ahead of earnings.
Recent market action is very revealing, in my opinion. First and foremost is that fears that without the Fed “no one will buy US debt” have proved to be completely unfounded. Everyone knows that the Fed is eager to end asset purchases this year, and yet magically there are enough buyers to keep 10 year rates locked below 3%. Without much, much faster growth and a real threat of inflation, we are stuck in a low interest rate world. Get used to it. Indeed, even when the Fed starts raising interest rates, I expect most of the impact will be in the center of the yield curve. We need to jump to a higher equilibrium path to boost long rates sustainably higher.
Also evident is that regardless of the Fed’s intentions, tapering is tightening, at least on a global scale. To be sure, emerging markets are under pressure from a number of directions. The yen’s decline over the past year was eventually going to pressure emerging market currencies. Commodity prices are softer than expected. Remember just a few years ago when the global commodity super-cycle would propel prices ever higher? That story appears to have come to an end. The ongoing adjustment in the Chinese economy is not helping matters either. Arguably, the Fed is only the icing on the cake.
But it is a cake of their own making. Ambrose Evans-Pritchard reminds us that emerging markets spent years leaning into the Fed’s low rate policies instead of leaning against. Now they are caught in the classic currency crisis trap – they try to raise rates to stem currency declines, but higher rates crush the local economy and, by extension, equity markets, which aggravates the currency decline. The process continues until the economy settles into a lower equilibrium. It isn’t pretty. Never is.
Funny thing is that what the Fed sees as no tightening is evolving into a global tightening now as central banks rush to raise rates. Consequently, money surges into the global safe asset – US Treasuries. And, interestingly, I think that you can argue that this is much, much more disconcerting than last year’s taper tantrum. This seems to me to be a pretty clear global disinflationary shock. And it isn’t like inflation was on a runaway train to begin with.
Bottom Line: The Fed wants out of quantitative easing. Policymakers want to normalize policy by bringing it back to interest rates. That sets a high bar to delaying the tapering process. Moreover, the leadership transition at the Federal Reserve also left policy on autopilot from December until March, raising the bar even further. That seemed to sink in today. They lack of offsetting on the part of emerging markets to easy Fed policy is now exacerbating the impact of tapering, creating a more significant monetary tightening than expected by the Fed. It is not clear when this alters the path of Fed policy. But what seems more clear is that the US is about to be hit by another disinflationary shock. That deserves careful attention, because inflation, I think, is at this moment the most important variable to watch as far as Fed policy is concerned. The Fed is pushing forward with tapering on only the forecast of future inflation. That forecast appears under threat.