When the MacroTourist and family visited the UK a couple of years ago, we spent the first week in Ireland. Although we enjoyed ourselves tremendously in England and Scotland, I found myself with a real soft spot in my heart for the Irish. I don’t know if this was the result that as a Canadian, I always think about our country as the underdog compared to our dominant US neighbour, and therefore find myself more sympathetic to the Irish. Or whether it was the simple fact Ireland has enough of a sense of humour to have a store called “Knobs and Knockers” in its downtown centre.
For whatever the reason, the warm, friendly nature of the Irish people have forever earned their country top marks as one of my favourite places to visit.
While we were in Ireland we stopped in at the Guinness factory where our three children (who were 8, 11 and 13 at the time) had their first (and somehow doubtful for last) taste of beer. Today is St. Patrick’s day, and I am quite confident there might be some more Guinness consumed today as the world celebrates Ireland’s most famous holiday.
For those of us that can’t slip into the pub to celebrate, we are forced to sit at our trading desks and confront the very real possibility there might indeed be bears straight ahead.
You see, apart from it being St. Patrick’s Day, it is also the start of the Fed’s two day FOMC meeting. The Fed meetings are always important, but some are more important than others.
This is one of those more “important-er” ones. The Fed finds itself in a little bit of a pickle. The wrong move could indeed bring out the bears in full force.
Since the end of October when the Fed’s third QE program was wound down, they have been waiting for an opportune time to start the normalization process of interest rates. The Fed was reluctant to raise rates too quickly as they had previously gone to great lengths to explain “tapering wasn’t tightening.”
Many at the Fed echoed Larry Summer’s view that the mistake would be tightening too soon, not the other way round:
“Deflation and secular stagnation are the threats of our time. The risks are enormously asymmetric,” said Larry Summers, the former US Treasury Secretary. “There is no confident basis for tightening. The Fed should not be fighting against inflation until it sees the whites of its eyes. That is a long way off,” he said, speaking at the World Economic Forum in Davos.
Therefore late last year and earlier this year, for many at the Fed it seemed like a no brainer to wait until the economy was firmly on solid footing before starting the rate hikes.
However since then, the economy has developed in a way that has put the Fed in a most awkward spot.
During the past few years the Fed has consistently pointed to the poor employment picture as the main reason for their excessively easy monetary policy. Even when inflation poked its head above the Fed’s target, they refused to ease up on their accommodation, stating that until labour market tightened, there was little reason to view inflation as anything except temporary.
Over the past couple of months there has been increasing signs that the much hoped for employment gains were finally coming to fruition. Many of the targets that the Fed set as conditions for tightening have finally been met.
Up until this point the Federal Reserve doves have managed to keep the hawks at bay. The large slack in the labour markets have been the swing factor in keeping the Fed Funds at the “emergency rate” of zero.
But now that the employment picture is improving, many of the hawks are squawking that the time for zero interest rates is long past. They want to start the process of normalizing rates, and the sooner, the better.
Yet Janet Yellen has a big problem. I am sure she would also love to have rates at a non-zero level as that would imply that the economy is strong enough to return to a more normal rate. But the problem is that apart from the improving labour picture, every other aspect of the US economy is slipping lower.
The US economic data has been consistently weaker than expectations during the past few months.
The US is finding it is not immune to the global economic slump. The threats of higher rates are even causing the problem to be all the worse. During the past six months the US dollar has risen at a rate that is the fastest in the history of modern day finance. This is causing more uncertainty and difficulty for companies dealing with the quickly changing economic conditions.
The last thing the Fed needs to do is make that situation worse.
So herein lies the problem for the Fed. They have made the promise that “emergency zero interest rates” would be removed when the labour market improves. Now that the labour market has improved, the Fed finds itself in the strange situation of having to tighten into a deflationary dip.
The Fed has never started a tightening cycle when inflation was running below target. Yet that is exactly what the hawks want Yellen & Co. to do.
It is a strange dilemma that the new Fed Chairwoman finds herself in.
This is the first day of the two day Fed meeting, so we will still have another day to think about how Yellen will navigate her way through this difficult jam. But I think I already know the answer.
There is considerable debate about the word “patient” in the Fed’s statement. During Yellen’s last testimony she went to considerable lengths to explain that removing the word patient does not mean rates will be raised in the immediate future. The absent of the word “patient” simply means that the Fed had the flexibility to take whatever action was needed. I have little doubt that the word “patient” will be removed from the coming Fed statement. The hawks are correct in their concern that the Fed is playing with fire having rates at emergency levels this far along in the economic cycle. The removal of this controversial word will be the dove’s sacrifice to the hawks.
But the removal of that word will be all the hawks will get. Everything else will be as easy as the Fed can allow. They will err on assuring the markets that rates will not walk straight up as in previous cycles. Yellen will echo Larry Summer’s commitment to fighting the new found secular deflation. The last thing Yellen wants to do is make a 1937 type mistake.
The world is slipping into a dangerous deflationary slump. The Fed will not push the world over the edge as they risk being dragged down with everyone else. The Fed’s mandate is quite clear. At the end of the day they are committed to price stability – both on the upside and downside. You might argue that this is a poor policy, but that doesn’t matter – it is what it is.
The market is way ahead of itself in its assessment of the Fed’s relative hawkishness. Tomorrow’s announcement will be a surprise in the other direction.