The Fed – bamboozled by the ambiguity

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Following the disappointing report on US non farm payrolls on 2 October, financial markets came in off the ledge in the first full week of October. Global equities, commodities and emerging market currencies posted their strongest week in several years. After dipping below 1 900 following the 2 October  employment report, US equity markets rallied sharply, with the S&P 500 closing at 2 014, up over 3% for the week. Financial market volatility as measured by the Chicago Board Options Exchange Volatility Index (VIX)—which had spiked to over 40 in August—closed the week at 17. Risk assets in fixed income also had a good week, with positive excess returns month-to-date for US investment-grade credit, which was up 34 basis points, US high-yield credit, which was up 167 basis points, and MBS, which was up 14 basis points.

The Federal Open Market Committee (FOMC) chose to leave the policy rate unchanged at its most recent meeting on 16-17 September . The minutes of that meeting were released on Thursday 8 October, and showed a Committee that is struggling to deal with the ambiguity of recent US economic data. The FOMC statement highlighted concern that recent global economic and financial developments may restrain US economic activity as these developments are likely to put downward pressure on inflation in the near term. Looking back at longer-term developments, we have seen strong improvements in labour markets, with unemployment rates at 5% and under-employment rates at 10%. For policy makers, this is suggesting that the US economy may well be in close proximity to full employment. No doubt, the output gap has closed substantially as well.

But questions about the Federal Reserve (Fed)’s outlook on growth and inflation persist. The Federal Reserve Bank of Atlanta revised its third-quarter GDP forecast downward to 1.1%, citing concerns about inventory drawdowns and declines in net exports. In fact, the US trade deficit reported this week widened more than anticipated as exports fell to their lowest level since June 2011 (see exhibit 1 below). US manufacturing is feeling the impact of a stronger US dollar and global economic headwinds. Does the recent weak trade and manufacturing data coupled with the weak payroll report alter the Fed’s outlook on growth? Is it really true that the deflationary impacts of falling commodity prices and a stronger US dollar are transitory? Why have the strong improvements in labour markets not translated into higher wages?

Exhibit 1: US trade balance – balance of payments (October 2009 – August 2015)

CotW

Source: Bloomberg, as of 9 October 2015

It will take time and more data in order to answer these questions. While the Fed’s September dot plot showed 13 of the 17 participants believing a rate hike would happen in 2015, it seems unlikely that it will happen at the October meeting. As the Fed points out in the minutes, while the time for policy normalisation might be near, it is appropriate at this time to wait. Wait for more information, wait for more data that the labour market continues to improve, that the growth outlook has not turned down and that inflation is on a path to 2% in the medium term.

For now, the more recent data suggest the balance of risks as it relates to growth and inflation has moved to the downside. The Fed will have more information for its December meeting (two more payroll reports and the numbers on third-quarter GDP) ‑ and let’s hope at that time it has less uncertainty about the ambiguity.

Image: Fed Chair Janet Yellen
Source : GongTo / Shutterstock.com
John Carey

CFA, Head of structured securities, FFTW

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