One Reason Market Turmoil Might Actually Make September the Ideal Time to Hike Interest Rates

No 1994 or 2004 repeats

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A number of sell-side economists have pushed back their estimates of when the Federal Reserve will deliver its first interest rate hike in light of the chaos in global markets.

Tighter financial conditions—such as higher rates, a stronger U.S. dollar, wider credit spreads, and lower equity prices—tend to trickle through to the real economy and have a deleterious effect on growth.

Goldman Sachs, for instance, estimates that the cumulative effect of the U.S. dollar rally since the second half of 2014 and the recent upheaval in equity and credit markets will amount to a 0.8 percentage point drag on real GDP growth by year's end.

But Torsten Slok, Deutsche Bank's chief international economist, sees a silver lining in this market turmoil that he figures actually makes a September liftoff look more attractive.

Investors, Slok reasons, will view a September rate increase as a policy error, in which case he would expect yields at the long end of the U.S. Treasury curve and the greenback to come under pressure. A flattening curve is generally considered an easing of financial conditions, and indeed it was one of the goals of the Fed's unconventional monetary policies in the first place.

"If anything, the narrative in markets at the moment is such that if the Fed does hike in September, then long rates and the dollar will decline because the market will think the Fed is hiking prematurely," Slok says in a research note. "Ironically, September may be the ideal time for the Fed to hike rates because given the way we currently talk about the economy in markets a Fed hike in September will likely be associated with an easing of financial conditions and not a tightening."

He asserts that the central bank ought to "do the first hike exactly when there is a bearish narrative in markets" to ensure it doesn't prompt yields further out along the curve to jump, as was the case in the infamous bond selloff sparked by 1994's rate rise.

The fly in the ointment, however, is that the Fed might be a little wary of having rate hikes result in an easing of financial conditions.

That's because, as Bloomberg's Matthew Boesler has pointed out, the Fed hasn't successfully tightened monetary conditions in 15 years, a period that encompasses the 2004-06 stretch of rate increases highlighted below:

Bloomberg

As such, what Slok sees as a potential feature of a September liftoff is something that—if it were to persist—could be a bug, as it proved to be during the previous hiking cycle.

Along with full employment, the other half of the Fed's mandate is price stability, and tighter financial conditions are the means to this end. By effecting tighter financial conditions, the central bank is able to dampen growth and thereby lessen inflationary pressures when it deems the economy is on the verge of overheating.

The Fed's failure to induce more restrictive financial conditions during the hiking cycle that began in 2004 is best represented by what became known as the Greenspan conundrum, as long bond yields failed to move higher in sympathy with the federal funds rate.

Among the contributors to the flattening yield curve back then were a global savings glut that helped put a cap on yields at the long end and the overly telegraphed and slow glide higher for the federal funds rate. Market participants ultimately brought about tighter financial conditions during the second half of 2008, with credit spreads exploding, the U.S. dollar surging, and stock prices tumbling.

So neither of the hiking cycles initiated in 1994 or 2004 looks like an attractive template for the Federal Reserve as it looks to embark on this next phase of monetary policy. This time is different for many reasons—not the least of which is the central bank's massive U.S. Treasury holdings, which presumably provide monetary policymakers with greater influence over the long end during the process of balance-sheet normalization.

At the present time, there's no need to wrestle inflation to its knees.

But whether monetary policymakers retain this power remains, for now, an open question.

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