The Fed's Conundrum

Monday 09/21/15

     Despite all the fanfare the fed decided to keep interest rates on hold last week. This newsletter will be a short recap of the important parts of the meeting.
     The only dissenter was Jeffrey Lacker who wanted to raise rates by 25 basis points.
     Probably the most interesting piece of information released by the fed was their dot plot shown in figure 1. The dots represent the views of what the FOMC (Federal Open Market Committee) participants saw as the appropriate level for the federal funds rate. I highlighted two dots in red that indicate that at least one member of the FOMC now thinks that negative interest rates would be appropriate. However, during the press conference Yellen clarified, “So, let me be clear that negative interest rates was not something that we considered very seriously at all today.” All FOMC participants contribute to the dot plot, not just the voting members, but if I had to guess who it was, I would suspect that it was either Kocherlakota (currently a non-voting member) or Williams (currently a voting member). I am basing my guess on their previously dovish nature. Yellen was asked who the dots belonged to, but did not provide an answer.

     The key line in the fed statement was, “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 other words, they’re worried that a slowdown in China and emerging markets will harm the U.S. economy. The fed has a conundrum though. They can’t normalize monetary policy without the dollar gaining in value. However, if the dollar gains in value it will put more pressure on China and emerging markets.
     There are a number of reasons why a strong dollar hurts emerging markets. One reason is that a strong dollar means that capital flows will reverse in the direction of the United States. Whereas capital had flowed into emerging markets in the past, helping them fund their deficits, they now have to adjust by either selling their reserves, raising rates or getting their fiscal houses in order. Certain countries are effected even further because of the dollar denominated debt. If you borrowed U.S. dollars to invest in Brazil, with the intention of making payments on that debt with income earned in Brazilian real, you have a big problem because the real has lost about 65% of its value to the U.S. dollar over the last year, but you still owe the same amount of dollars.
     The fed also sees “transitory” factors that are contributing to slower growth and inflation. Of course, there is a good chance that the fed doesn’t really understand what the word transitory means since they have been blaming transitory factors for years now. During the press conference Yellen said,

…in light of the heightened uncertainties abroad and a slightly softer expected path for inflation, the Committee judged it appropriate to wait for more evidence, including some further improvement in the labor market, to bolster its confidence that inflation will rise to 2 percent in the medium term. Now, I do not want to overplay the implications of these recent developments, which have not fundamentally altered our outlook.

     I interpret that quote to mean that they want to see how the upcoming wage increases that I discussed in last week’s newsletter play out. It also means that they realize that there isn’t a strong reason to raise rates because inflation is subdued.
     Even though the vote was lopsided in favor of holding rates, it sounds as though the FOMC has become more as hawkish in tone. This morning non-voting member Bullard was on CNBC stating that he was also in favor of raising rates at the current meeting. Next year Bullard will be a voting member along with Esther George and Loretta Mester who I would categorize as slightly hawkish, very hawkish and slightly hawkish respectively. If the fed does not raise rates this year, it will become much more likely in 2016. The fed does not want to look divided in its decision because it will add an element of uncertainty to the market and the fed’s credibility could be brought into question. So even fed members that are in favor of dovish monetary policy will need to consider the implications of a confused market.