Fed: Hawkish hold on the cards - BBH

Research Team at BBH, suggests that investors’ focus will be on two central bank meetings in the week ahead:  the Bank of Japan and the Federal Reserve.  

Key Quotes 

“The former is shrouded by a greater degree of uncertainty.  It has repeatedly surprised investors.  In contrast, investors appear as confident as they can be that despite some signals to the contrary, the Federal Reserve will take the next step on the path that it says it is committed of gradual normalization of its policy rate.

While investors will keenly watch what the BOJ does, they will scrutinize what the Fed says.  If the Fed does not raise rates, then the dot plots will have to be downgraded to reflect the possibility of only one hike.  At the end of last year, the median expectation by Fed officials was that four hikes in 2016 would be appropriate.  The Federal Reserve rejects the criticism that it has over-promised and under-delivered.  Fed officials and Yellen, in particular, have been careful to stress that the dot-plots are not commitments or promises.

However, if the Fed wanted to address the skeptics and keep the market prepared for a hike at the December meeting (there is precedent for a hike in September of an election year, but not November), there are a few things it can do.  First, it can reintroduce a formal risk assessment that was dropped earlier this year.  Second, it can indicate that the burden of evidence has shifted from needing to show continued improvement to as long as there is no deterioration, the Fed is prepared to raise rates.

Third, it can express greater confidence that the economy has weathered the bulk of an inventory cycle that has restrained growth for the past three-quarters.  It can also be more confident that between rents, medical services, wages, and the diminishing impact of past dollar appreciation and the decline in oil prices, price pressures can be expected to increase gradually.  It can cite the steepening of the yield curve and the increase in the break-evens as evidence that market-based measures of inflation expectations have also been lifted.

Unlike Governor Brainard’s recent comments, the FOMC statement may recognize diminished global risks.  The UK referendum has come and gone with minimal disruption.  The potential disruption from China (from the yuan and equity market) appears to have also lessened, and the world’s second largest economy appears to be stabilizing.  Both the eurozone and the Japanese economy also are growing near trend.

One dissent to a stand-pat policy at the Fed would not be surprising (e.g. George), but a second one would be part of a “hawkish hold.”  At the same time, we argue that the impact of a 25 bp rate hike in the Fed funds target is being exaggerated by policymakers and investors alike.  Expected returns for medium and long-term investors do not change very much on a quarter-point hike, especially, as the real rate (adjusted for inflation) remains below zero.

It seems some would say that a 25-50 bp Fed funds target does not equate with prudence and caution and is too accommodative, while others may say that 50-75 bp target is imprudent, reckless and is tantamount to introducing a tight monetary policy.  Quite frankly, if the Fed tightens, monetary policy would remain accommodative by nearly every conceivable metric, but simply a little less so.

The Fed’s critics complain of its communication style, even though Yellen strikes us as among the most plain-spoken Fed Chairs in modern times.  Recall, Greenspan’s admonishments that if one thought they understood what he said, they misunderstood.  Bernanke may have been prone to having a professorial voice and (arguably) over-sensitive to minor nuances.”