You know when “how to understand the Fed” guides appear in the mainstream press that the policy decision tonight has become the most over-analysed ever. So I am not going to add much to the debate here, other to give a short summary of my views.
At the start of the year I expected the Fed to hike in June (eg see here and more recent views here). Two things put paid to that: much weaker than expected growth in Q1 and a further sharp fall in energy (and other commodity) prices. But despite the additional breathing space those factors gave the Fed before starting the normalisation process, the FOMC continued to send the message that the first hike was not too far away. Indeed, the impact of energy prices has been described as transitory, as was much of the weakness in Q1 activity. We now know that Q1 wasn’t quite so bad, and that Q2 was really pretty strong. Averaging out for a slightly above trend H1. Not the very rapid growth of 2014H2, but decent. Alongside that, the labour market continues to improve, with payrolls growth averaging above 200K and broader measures also improving.
The last shoe to drop – wage growth – remains surprisingly weak, but has shown some signs of picking up (albeit somewhat blurred by some noise in the data). Headline inflation remains very low due to energy, but core has been surprisingly strong (in my opinion) given: a) the dollar move; b) second round effects of lower energy; and c) Obamacare. These are probably worth over 1pp in total, and should all drop out in the next 6 months or so. Indeed shorter-run annualised inflation rates have already picked up.
So given the domestic economy looks on track, surely it is time for the Fed to start the normalisation process? They have been clear that they expect inflation to rise back to target. But how confident are they in that prediction? The IMF seem to think that they can’t be confident about it until it happens! That is ludicrous in my view. We wouldn’t see the first hike until mid-2016 at the earliest. And the likelihood inflation overshoots after that is high, requiring a more rapid and difficult tightening. Others argue that the NAIRU is clearly much lower, or that a broader measure of labour market slack imply far more spare capacity still to work off. And therefore there is no rush to start tightening yet. But I am not (yet) persuaded by these arguments, and I don’t think the majority of the FOMC are either.
But the impediment to hiking that most in the market have focused on for the past month has been the increase in volatility associated with uncertainty about the outlook for China (and the rest of the EM complex). Indeed, the resulting equity sell-off and spike in VIX was enough for most to rule out a hike in September. I am more sanguine about both the volatility and the causes of it (see here for my thoughts). To be sure, if China is about to have a seriously hard landing, then global growth is going to be impacted, and the Fed probably won’t tighten as quickly, or maybe as soon. But I think the jury is still out on just how bad things are in China. Global markets have stabilised somewhat, and equities have recovered about half of their losses.
So my bottom line is that I think the Fed are very close to starting the normalisation process. Market pricing has the probability of it starting in September at a little under 1 in 3, rising to over 50% by December. I think it is closer to 50% today, but I probably fall on the side of no change, albeit without much conviction.
I suspect if it is no change, that Yellen will want to keep October on the table, by suggesting they could have a press conference if necessary. I also expect that the dots will be a little lower given the risks to global growth and inflation. As for the market reaction….the people I have spoken to this week don’t seem to have a strong view either way. I have heard arguments for a risk rally on both a hike and a hold and vice versa. While the decision itself clearly matters (as it tells us something about the Fed’s reaction function, and therefore likely pace of hikes), what will probably matter more is the tone of the press conference. I think Yellen will be cautiously optimistic about the outlook. Which might bring a bit of term premia back into the curve and see the dollar rally.