Deutsche Bank’s chief US economist Joe LaVorgna doesn’t think the Federal Reserve will raise interest rates until the market says it’s ok.
In a note to clients on Thursday, LaVorgna said that basically, the Fed is on hold until markets make clear that they are ready to handle a change in the Fed’s posture.
LaVorgna wrote on Thursday (emphasis his):
Most importantly, the financial markets have to be discounting a reasonably high probability of an interest rate hike. In other words, the Fed will not surprise the financial markets with a tightening in policy. (Unfortunately, this is how monetary policymakers have conditioned the financial markets over the years.) The difficult part for the Fed will be convincing the markets that the funds rate can go up next month.
LaVorgna’s note outlined seven things he’ll need to see from the Fed for an October rate hike, a call that comes just one day after LaVorgna gave up his call that the Fed will raise rates next week. The Fed hasn’t raised rates since July 2006 and hasn’t initiated a rate hike cycle since 2004.
Now, LaVorgna’s belief that the market is the tail wagging the Fed’s dog isn’t necessarily an outside view, but it is a somewhat surprising admission coming from a major Wall Street bank.
Currently, the Fed’s dual mandate calls for it to focus on achieving full employment and price stability (which the Fed defines as 2% inflation). And while not part of its mandate, the Fed also strives to maintain financial stability.
In a speech last December, Lael Brainard, a member of the Fed’s board of governors and a voting member of the Federal Open Market Committee — which votes on monetary policy decisions — said, “safeguarding financial stability is deeply ingrained in the mission and culture of the Federal Reserve Board. Today, financial stability is more important than ever to the work of the Federal Reserve Board.”
And so on the one hand, we can’t ignore that the Fed will look to the markets to gauge how much a change in its policy stance can be tolerated. On the other hand, the Fed’s mandate is clear.
We’re now about seven years past the outbreak of the financial crisis, though the Fed’s zero interest rate policy is still very much a crisis-era positioning.
Last Friday, we learned that in August the unemployment rate fell to 5.1%, the middle of the Fed’s range at which it would consider the economy at “full employment.”
Inflation, however, remains stubbornly low, with “core” PCE, the Fed’s preferred measure of inflation, running at around 1.2% annually in August.
Stanley Fischer, vice chair of the Fed and seen as the most influential member outside of chair Janet Yellen, said in a speech at Jackson Hole that the Fed need not wait for inflation to return to its 2% goal before raising rates. In effect, Fisher’s words were seen as giving the Fed the green light to act.
But as some have written — notably The Wall Street Journal’s Jon Hilsenrath — the Fed hasn’t made any policy changes without clearly telegraphing its intentions. And with one week to go before the Fed’s next policy announcement, what the Fed does next is anybody’s guess considering we haven’t heard from Yellen in 2 months and Fischer’s words were less than committal.
The market, however, is pricing in a roughly 30% chance the Fed raises rates: a little more confident than a guess.
And this is part of what LaVorgna thinks the Fed needs to see change before it acts.
There’s an argument to be made that if the Fed wanted more clarity from the market it could simply be less opaque in its communication, laying out clearly that it will or will not act at its next meeting (perhaps like it did in its March statement when it said, “Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting”).
The eternal criticism from opponents of the Fed’s post-crisis policy is that, well, the Fed did this to themselves. By keeping rates at 0 and engaging in large quantitative easing programs, the Fed distorted markets. Under this framework, then, the Fed’s next move will basically be a disaster no matter what.
But even if you think the Fed has acted appropriately and done the best it could’ve in response to the financial crisis, it seems that markets are going to have a negative reaction to the Fed’s next move no matter what. In fact, there’s a good case to be made that much of the uncertainty around the Fed’s next move has been a major catalyst for the recent volatility we’ve seen in the stock market.
Ultimately, the market — which is the Fed Funds futures contract — is merely reacting to the Fed’s seven years of zero interest rates, and as far as we’re concerned it’s hard to see how the Fed would convince markets they’re going to act without either 1) telling them or 2) acting.
If the Fed isn’t going to do the first, the only choice it has, it would seem, is to do the second.
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