Markets' Focus on Timing of Fed Hike Is a Distraction
It is unfortunate to see market participants and observers obsess so much over the exact timing of the Federal Reserve’s next interest rate hike. Speeches and comments by Fed governors and regional presidents are dissected for any hint: Will it be next week or will central bankers wait until December?
Although this focus creates unnecessary financial volatility -- especially the closer we get to the Sept. 20-21 Open Market Committee meetings -- a calm examination of lasting drivers of economic activity and asset prices tells us that the timing of the next rate hike shouldn’t matter that much. Moreover, the extent to which the Fed can have an impact on economic and financial prospects depends on a much broader array of factors, an increasing number of them outside the central bank’s direct purview.
So, as tempting as it is to partake in the timing mania -- and I am as vulnerable to that temptation as anyone -- here are five major issues to watch to help maintain our individual and collective sanity:
- Will the exact timing of the next Fed hike have an impact on where policy rates are likely to settle at the end of the cycle, the so-called terminal value?
No, it won’t. The terminal value is determined by a much broader set of economic and financial variables that are largely independent of the timing of the next hike. They include productivity, the structure of the economy, the depth of financial intermediation and the interactions with the rest of the world. There is also growing recognition, both within and outside the Fed, that the probable terminal value (somewhere in the 2-3 percent range) will be notably below historical averages.
- Will the timing of the next hike influence the path of the cycle?
Again, the answer is no; and, again, there is now broad recognition that this cycle will be atypical in historical terms: It will be very shallow and unusually elongated, and the increases will occur at irregular intervals, and could occasionally be reversed.
- Will the timing alter what other systemically important central banks do?
It’s highly unlikely. As they contemplate additional stimulus, both the European Central Bank and the Bank of Japan have much more important considerations to take into account that are a lot closer to home -- including the possibility of weaker economic activity and a renewed deflation risk, as well as the need to assess the unintended consequences of negative rates and the concern that monetary policy become may become a lot less effective or, in the case of the Bank of Japan, counterproductive. Meanwhile, the Bank of England is trying to find a path through the yet-to-be-fully defined modalities of implementing the U.K.’s vote to leave the European Union. And the People’s Bank of China is dealing with issues of its own as the country navigates a complex “middle-income” development transition.
- Will the timing -- and, in particular, a September hike -- alter the short-term prospects for financial asset prices?
Probably yes. In theory, the most sensitive assets would be shorter-maturity bonds and exchange rates, though the impact should not be large and systemic given the three preceding points. In practice, however, higher volatility could ensue given the excessive dependence of markets on central bank support, and thus could bring a wider set of asset classes into play. This is particularly true because markets are still attaching too low a probability to the likelihood of a rate hike next week, despite repeated indications to the contrary from several central bank officials.
- Will the timing of the next rate hike affect the economy?
There could be some immediate spillover from higher financial volatility, but it is likely to be temporary and contained. Economic prospects are much more dependent on three other factors that are outside the control of central banks:
• The likelihood of a policy pivot away from excessive dependence on central banks and toward a more comprehensive policy stance that, at a minimum, would set in motion fiscal and pro-growth structural reforms;
• Productivity trends, including the role of innovation and infrastructure investment in countering the overall sluggishness;
• Developments in China and Europe
All of this leads back to a concern that has preoccupied me for some time: Not only have markets become overly dependent on continuous liquidity support -- via share repurchases by companies or, more importantly, through central banks maintaining ultra-low rates and, in the case of Europe and Japan, extending and expanding their large-scale asset purchase programs. They also have grown accustomed to the idea that monetary policy will continually be held hostage to the risk of financial volatility.
The longer this persists, the more asset prices will be divorced from the realities of economic and corporate fundamentals; and the greater the risk, down the road, of the kind of financial instability that undermines economic growth and prosperity.
Domestic and economic factors are finely balanced when it comes to whether the Fed should increase interest rates this month. Yet macro-prudential considerations should be a tie-breaker that favors an increase, followed by a shallow rate cycle and a lower terminal value. In addition, other policy-making entities should step in to relieve the central bank by accepting their policy responsibilities and acting on them.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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Mohamed A. El-Erian at firstname.lastname@example.org
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Max Berley at email@example.com