A hawkish hold

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In recent months, two major themes have dominated investor discussion of the market outlook: uncertainty over China’s growth trajectory and a possible start to monetary policy normalisation in the United States. Regarding China, there has been little clarity about the growth outlook since these uncertainties rose to the fore. If anything, authorities’ interventions in equity markets, as well as poor communications around the adjustment in the foreign exchange regime, have only served to undermine confidence in the leadership’s ability to take appropriate steps to support growth during implementation of an ambitious reform agenda.

If an uncertain outlook for China has been a prime contributor to de-risking and elevated volatility, the US monetary policy setting remains unlikely to provide much of an offset. The Federal Open Market Committee (FOMC) decided at the 16-17 September meeting against beginning policy normalisation and released a more subdued projection for the path of policy rates. Still, we viewed overall communications from the Committee in a somewhat hawkish light. This is because most Committee members continue to project a policy rate increase later this year, even though the conditions that led to a delay in lift-off are likely to persist in the months ahead. Namely, we expect China’s economic transition to continue to impart disinflationary pressures globally and concerns about growth in many emerging market economies to remain elevated. At the same time, so long as US policy normalisation hovers on the horizon, the US dollar will continue to trade with a strengthening bias, especially since many other central banks are easing policy and expectations for additional quantitative easing by the ECB will only mount.

In this environment, it is increasingly difficult to see how the Committee will establish “reasonable confidence” in the inflation outlook and begin raising rates this year. The underlying issue is that an inflation framework based on labour market slack may not put sufficient weight on global factors that impart a disinflationary bias. There is evidence that confidence in this framework has eroded over recent months. For example, in addition to doubts that Stanley Fischer raised in his Jackson Hole speech, the September policy statement explicitly referenced “global economic and financial developments” that will put further downward pressure on inflation. Yellen also emphasised these developments in her press conference. Still, the Committee continues to see these factors as temporary in nature, and most members continue to expect an initial rate increase later this year. Indeed, since the 16-17 September meeting, a number of Committee participants have portrayed the decision not to raise rates as a “close call”. But viewing low inflation as temporary is an outlook that investors increasingly view with skepticism, and market expectations for an initial rate increase by year-end have declined since the FOMC meeting. Market-based measures of forward inflation compensation also remain near post-crisis lows (see exhibit 1 below).

Exhibit 1: Market-based measures of forward inflation compensation remain near post-crisis lows – here the US 5-Year / 5-Year forward breakeven inflation swap rate
(1 August 2005 – through 18 September 2015).

Inflation1

Source: Bloomberg, as of 18 September 2015

Ultimately, the Committee may need to improve its communications to ensure that its eventual move towards policy normalisation is not viewed as premature. Should inflation numbers weaken further, the Committee may find it difficult to continue to highlight a case for lift-off by the end of the year. Conversely, once again communicating a somewhat later lift-off would only serve to keep market uncertainty about the near-term policy outlook elevated and could weigh further on risk assets. In such an event, a better approach would be to replace the “reasonable confidence” language in the policy statement with a stronger commitment to delaying lift-off until core inflation shows a clear trend towards 2%. This would provide greater visibility into the conditions that would prompt lift-off, support inflation expectations, and ease financial conditions – essentially converting a hawkish hold to a dovish one.

Steven Friedman

Senior Investment Strategist

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