- Markets are betting that Fed will delay rate hike until 2016
- Weighing headwinds from slower China against domestic strength
Janet Yellen has a chance this week to do one of two things: emphasize that the Federal Reserve remains on track to raise interest rates in 2015, or validate the view of many investors that liftoff will be delayed until next year.
The Fed chair delivers a speech Thursday in Amherst, Massachusetts, on “Inflation Dynamics and Monetary Policy.” She won’t take questions, so it’s up to Yellen to decide if she wants to guide market expectations by clarifying whether she is among 13 of 17 officials who saw a rate rise as appropriate this year.
Those projections, displayed as dots on a chart, were released at the Sept. 16-17 Federal Open Market Committee meeting, when officials held rates near zero amid financial market turmoil and uncertainty over what slower global growth means for the U.S. outlook.
Yellen told the post-FOMC press conference that a rate rise this year was a “fair summary” of the committee’s assessment, provided the economy grows as expected, while declining to identify her own forecast. If she gives more clarity on her personal outlook for the economy and the appropriate timing of liftoff during her remarks at the University of Massachusetts, it would be a powerful signal to markets.
Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, said Yellen has to start making the case now. “They don’t want to surprise the market, which means they have to lay out a course of action before they can be sure they are going to follow it,” he said. “They have a communications mess on their hands.”
There are two remaining FOMC meetings this year. Investors see the chances of liftoff in October as only around 20 percent, while a hike by December is less than a 50-50 proposition, according to trading in federal funds futures. That’s down from the roughly 65 percent chance traders assigned to a 2015 hike on Sept. 16, despite subsequent comments from Fed presidents John Williams of San Francisco and Dennis Lockhart of Atlanta, both 2015 FOMC voters, who expect to move this year.
Shifts in market expectations probably won’t go unnoticed. Fed officials have discussed the danger of catching investors off-guard, according to minutes of their April meeting. That discussion recalled the so-called 2013 taper tantrum, when Treasury yields soared at then-Fed Chairman Ben Bernanke’s suggestion the Fed could start reducing bond purchases.
“The market is really second-guessing them,” said Michael Hanson, senior U.S. economist at Bank of America Corp. in New York. “There doesn’t seem to be an easy way to get from where we are today to a rate hike in 2015 without some additional volatility. The market just isn’t there.”
The communications challenge for Yellen and her colleagues is how to describe two competing forces as they weigh liftoff: downward pressure on inflation coming from slumping prices of imported goods and commodities due to a stronger dollar and slowing growth in China, versus steady U.S. consumer demand that they believe should push domestic prices higher as unemployment falls and the labor market tightens further.
The jobless rate is already low at 5.1 percent and the median forecast of Fed officials last week showed it averaging 5 percent for the final quarter of the year. On the other hand, inflation as measured by their preferred gauge has been under their 2 percent target since April 2012 and was just 0.3 percent in the 12 months through July.
The picture is further clouded by the ongoing instability in financial markets that could serve as a warning that U.S. growth prospects may not be as insulated from a global slowdown as the Fed’s forecasters expect.
No Big Deal
“Economic and financial models tell them that a 3 percent devaluation of the Chinese currency really should not be that big of a deal for growth in the U.S.,” said Jim Caron, a money manager at Morgan Stanley Investment Management in New York. “But you wouldn’t know it by looking at the markets. The markets are telling you, actually, we are kind of worried about this.”
Last week’s FOMC statement noted that “recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term,” in a nod to the market instability sparked by China’s surprise Aug. 11 devaluation of the yuan.
The problem is it could take months for the committee to get clarity on what China’s economic adjustment means for economic growth and inflation here in the U.S., and the threat of a hike before year-end hanging over the market will only add to the uncertainty, according to Bryan Carter, lead portfolio manager for emerging-market debt at Acadian Asset Management LLC in Boston.
”Short-end rates move higher as the Fed gets closer to hiking, and that causes the dollar to strengthen, and that causes global funding stresses,” said Carter, a former U.S. Treasury economist. “They are creating the conditions that are causing the external environment to be weak, and then they say they can’t hike because of those same conditions that they have created.”
For more, read this QuickTake: The Fed’s Countdown