Twice burned, thrice shy

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2015 has proven to be an extremely challenging year for Federal Reserve (Fed) communications and for the credibility of the central bank’s forecasting. On two occasions, policy makers communicated that a start to policy normalisation was just around the corner, only to determine that lift-off would need to be delayed due to disappointing economic data and tighter financial conditions. Even if twice delaying has been the appropriate decision, the ongoing cycle of pushing off the first rate increase so that it continuously hovers on the horizon has contributed to market uncertainty and volatility. Market angst over this state of play was particularly high following the 16-17 September meeting, when the strong focus on international development further clouded perceptions of the Committee’s reaction function.

Given these dents to its credibility, it is remarkable that the Federal Open Market Committee (FOMC) took the risk of strengthening its language around lift-off in the October meeting statement. Most importantly, the statement referenced conditions for determining whether it would be appropriate to raise rates at the next meeting in December. By contrast, all prior statements this year focused on conditions for maintaining rates near zero. This is a subtle but material change ‑ the Committee would be well aware that investors would interpret the new language as a strong signal that lift-off could occur in December. It would not risk further damaging its credibility unless this was indeed the case. Thus the language changes were more than an attempt to tweak market expectations and regain optionality to raise rates in December (see Exhibit 1 below) ‑ they represent a clear signal that the Committee has a high degree of confidence that incoming data will conform to its view that the economy has sufficient underlying strength to weather gradual policy normalisation.

Exhibit 1: Market expectations and FOMC projections for policy rates 

FOMC

(Note: “Core FOMC Projection” uses the fifth lowest rate projection among FOMC participants as a general indicator of the views of core policy makers.)

Source: Bloomberg, Federal Reserve, Summary of Economic Projections, September 2015

The Committee’s growing confidence stems from a number of factors. First, base effects related to earlier sharp declines in oil prices should kick in around the end of the year, boosting headline inflation. Second, financial conditions have eased a bit due to diminishing concerns over China’s growth trajectory and foreign exchange policy, easing by the People’s Bank of China and expectations that the ECB will provide further stimulus. And third, the underlying pace of domestic final demand remains healthy at around 3%. These factors point to a relatively low hurdle for December lift-off so long as household consumption and the service sector remain resilient to weakness in the oil, gas and manufacturing sectors. In this regard, the employment report to be published on Friday 6 November bears close scrutiny for any evidence that job losses in these sectors are spilling over to service sector jobs. Should these spillovers remain limited, and if non-farm payrolls growth registers above a 150 000 monthly pace heading into the December meeting, the Committee is highly likely to commence policy normalisation at that time.

A Committee growing increasingly comfortable with a December rate increase is not the only important lesson from the October meeting. A second one is that investors appear to view a rate increase at that time as appropriate, judging from the market reaction. After the statement release and through the end of the trading day, US equity indices moved higher, and long-term nominal Treasury yields rose. Market-implied breakeven inflation rates have also remained stable since the meeting. As a whole, none of the price action reveals investor concern that the Committee will make a policy error by raising rates. As such, the start of policy normalisation should lead the term structure of US rates to price higher as the Committee’s outlook for the economy implies a policy rate path that is steeper than what is currently reflected in market pricing.

A final and important lesson is that the market still does not yet share the Committee’s confidence that economic conditions will allow for policy normalisation to begin in December. Implied rates on interest rate futures contracts priced notably higher following the October meeting, but only reflect about even odds of a rate increase by the end of the year. Perhaps having twice been led astray by the Committee’s projections for a near-term rate increase, investors will require even more convincing evidence that the economy remains resilient to global developments and slowing in goods-producing sectors. Should this evidence emerge, a meaningful market repricing of the path of policy rates remains a strong possibility.

Steven Friedman

Senior Investment Strategist

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