Ghost of September's Delay Haunts the Fed on Eve of Liftoff Decision
As members of the Federal Open Markets Committee meet in the nation's capital this week, some might be having an eerie sense of déjà vu.
Measures of financial conditions are close to or above levels seen on the eve of the central bank's September meeting:
The dramatic market selloff that followed the shock devaluation in early August of the Chinese renminbi and a stretch of lackluster global economic data was enough to stay the Federal Reserve's hand back in September. Those developments "may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term," the FOMC said then.
Recently, high-yield bond spreads have blown out as oil sank to fresh multiyear lows, with signs of contagion in other sectors. Meanwhile, the U.S. trade-weighted dollar has advanced to its highest level in over a decade. These two related developments are the prime culprits for the tightening of financial conditions—a composite measure of bond yields, credit spreads, stock prices, the strength of the U.S. dollar, and other market variables—seen in December, just days before the Fed is expected to raise rates.
Unlike in September, however, upward pressure on financial conditions has intensified, not abated, in the runup to the Fed's meeting.
"With the framework the FOMC is using, it's time for them to think about whether [tightener financial conditions] are going to sufficiently hold back the [U.S. economic] expansion from here," said Torsten Sløk, chief international economist at Deutsche Bank.
Sløk anticipates that robust job growth since September's meeting will cement the case for liftoff, leaving monetary policymakers to "twiddle their thumbs and watch their screens to see how the economy reacts to a rate hike" before continuing with the tightening phase.
RBC Capital Markets senior economist Jacob Oubina, however, finds the situation materially different from what occurred in the late summer, pointing to an equity market that remains within 4 percent of its all-time closing high.
"Where's the stress besides high yield, and what do you think helped cause that?" he said, alluding to the prolonged period of near-zero interest rates that boosted riskier asset prices and aided the shale boom. The source of this recent virus, he suggested, can't also be the cure.
As the implied probability of a rate hike is far greater than it was right before September's meeting, this tightening of financial conditions also reflects, to a certain degree, increased confidence that the prophesied divergence in monetary policy will actually be carried out.
Other economists noted that pulling the football away yet again would send a perverse signal that the tail is wagging the dog.
"If each time financial conditions are soft the Fed balks, then the market is calling the shots, not the Fed," said Drew Matus, UBS deputy U.S. chief economist, who posited that an additional delay would make the market uneasy that the central bank knows more bad news than it's willing to let on. "Consider the market response to September and think about what might happen if the Fed held off this time. What would they guess the reason would be?"
In the end, the level of financial conditions may be of less importance to monetary policymakers, who are itching to get away from the zero bound, than the idea that the global economy has bounced back from its summer malaise. September marked an intermediate bottom for manufacturing purchasing managers' indexes in the euro zone, China, and broader emerging markets, suggesting that the rest of the world is starting to gain economic traction:
There are "some important differences between August and the situation today, including that the China hard landing scenario appears much less likely and that the global economy has stabilized over the past two months," concluded credit strategists at Bank of America Merrill Lynch.